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What Is A Personal Loan And How Does It Work?

Scott Steinberg3-minute read
February 23, 2022

Ever feel short on cash? If so, a personal loan can help. But what is a personal loan exactly and how does it work in practice? It’s important to do your research and know just what you’re signing up for before applying.

In effect, by allowing you to borrow money from a financial institution, a personal loan can help you cover a host of expenses from mortgage payments to college tuition and medical bills. Should you ever find that a few extra dollars would come in handy quickly, a personal loan may be a good option, especially if you’re need in of cash fast.

Let’s take a closer look at different types of personal loans and if you should consider applying for one. You may be surprised at just how common and helpful a personal loan can be.

What Is A Personal Loan?

A personal loan is a form of installment loan that is granted by a financial institution (bank, credit union, etc.) to an approved borrower. Under the terms of a personal loan agreement, you’ll agree to repay any sums lent over a fixed timeline, typically spanning a range of 2 – 5 years.

How much you can expect to pay in APR on this type of loan varies by your individual credit score, credit history, and lender. Nonetheless, under the terms of most personal loans, the APR will be fixed for the duration of the loan. In other words, you won’t have to worry about jumps in interest rates increasing your monthly loan payments in turn.

Note that in the case of personal loans, funds are typically disbursed quickly following loan approval – sometimes within the same day. Once you have received any monies paid out from the loan, the repayment timeline goes into effect, and your lender will expect you to make monthly payments in a timely fashion.

How Do Personal Loans Work? 

Anyone wishing to obtain a personal loan will need to apply for the loan with, and be qualified to receive one by, a financial lender. As part of the application process, lenders will review your credit score, credit history, debt-to-income ratio (DTI), and other factors such as your current income and expenses.

If you are deemed creditworthy by the lender, they will elect to extend a personal loan to you on a specific repayment timeline and mutually agreed set of loan terms. To maintain a good credit score, and positive standing in future lending partners’ eyes, it’s important to make timely payments on any sums borrowed, which must be repaid as agreed over the entire life of the loan.

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Types Of Personal Loans

There are many different kinds of personal loans available depending on your individual financial situation and needs.

Unsecured Personal Loans

An unsecured loan is not backed by collateral such as a piece of real estate or vehicle. Instead, your lender will determine whether or not to extend an unsecured loan to you based on your credit history, credit score, DTI ratio, and other factors. An unsecured personal loan is the most common type of personal loan issued today.

Secured Personal Loans

On the flip side, secured loans require borrowers to put down collateral (like their house or car) to qualify, which can be repossessed if the borrower defaults on the loan. Secured loans are typically issued to those with a lower credit score or less well-established credit history, causing them to be viewed as more of a lending risk in financial institutions’ eyes.

What Is A Good Reason To Get A Personal Loan?

From sudden, unexpected emergency expenses to rising costs of living, many good reasons exist to look into the possibility of obtaining a personal loan. Reasons for seeking a loan out will vary from person to person and family to family, with millions of individuals looking to personal loans to help improve their budget and cash flow every year.

Debt Consolidation

Personal loans are often used to aid with debt consolidation. Such loans are often unsecured, and used to help roll multiple debts up into a single payment, or help pay down credit card debt, as these loans tend to come with lower interest rates attached. In short, personal loans can help you minimize confusion (by making it possible to not have to juggle multiple loans, each with their own particulars). Likewise, they can also help you refinance pricier debt down to a lower rate, thereby helping you lower your monthly payments.

Expensive Events

Weddings, honeymoons, vacations, car expenses and other major purchases can all put a big dent in your budget. After all, cars are notorious for breaking down when you least expect it, and repairs can cost a pretty penny. Likewise, because you’re often hosting and catering for dozens of friends and loved ones, wedding expenses can quickly add up, as can the total bill for taking a family holiday. Personal loans can help you fund life’s pricier occasions.

Investing In Yourself

Perhaps you’re starting a small business or trying to get a new startup venture off the ground. Maybe you’re planning on going back to school or obtaining a new certification. Whatever the case may be, a personal loan can help you better afford related expenses.

Home Improvements

Considering remodeling your kitchen, putting a pool in your backyard, or landscaping the front lawn? A personal loan can help you pay for a host of new home improvements. Such a loan would normally be unsecured in nature – and may prove to be a better choice as a lending option than a home equity loan or home equity line of credit (HELOC), as it doesn’t require you to put your home down as collateral. Personal loans can be applied in a host of ways to help you improve the functionality and appearance of your home.

Emergencies

Emergencies happen and, unfortunately, often come with high price tags attached. Such emergency-related expenses may come in the form of medical bills, funeral costs, or even costs of pet-related care. Ask yourself: When was the last time you saw a sprained ankle or dog or cat with a sick tummy coming in advance? These incidents can be hard to predict, and even harder on your pocketbook – thankfully, a personal loan can be a huge help when it comes to covering unforeseen doctor or vet bills.

How To Apply For A Personal Loan

It’s often easier than you think to apply for a personal loan, which is typically provided by a bank, credit union, or online lender. More often than not, your hardest task will simply be picking the right loan package and lending partner for you.

1. Prequalify With Multiple Lenders

Individual lenders vary in how much money that they’re willing to lend to borrowers and on what terms. That’s why it’s important to shop around and get a feel for what types of offers different lenders might extend to you. As part of your research, you’ll want to make a point to compare options from three to four (or more) providers to determine the best APR, loan terms, and loan amount for you. Seeing what you can prequalify for will help you decide. Having done your homework, you’ll be far better prepared to pick the right personal loan package and partner for you.

2. Gather And Submit Documents

Once you have decided on a lender and specific loan product, you’ll need to formally apply for a personal loan as a borrower. That means having to demonstrate your creditworthiness and having to qualify with your lender. Prior to loan application, take time to gather financial documents such as pay stubs, bank statements, information on investment holdings, and details on your employment. Lenders prefer borrowers with a strong credit history, good credit score, and enough regular income to maximize odds that the loan will be repaid in a timely fashion.

3. Receive Personal Loan

Congratulations! After your application has been approved, you’ll be ready to receive any sums that you’ve been cleared to borrow. Any loaned monies should be transferred to you within the next few days, or possibly even the same day, depending on your individual lender.

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The Bottom Line: There Are Plenty Of Benefits To Obtaining A Personal Loan

Life is full of unexpected surprises and tends to get pretty darn expensive at times. Important moments like getting married, making a new car purchase, starting a new business, or sending a loved one off to college usually require a big investment. Naturally, a little extra cash can come in handy during these instances … let alone when unexpected medical, auto or pet-related emergencies strike.

A personal loan, which allows you to borrow money from a financial institution under set terms and interest rates, can help provide the cash that you need to cover these expenses and more. In return for receiving these sums, you agree to pay back any monies lent plus interest over the course of a fixed time period (generally 2 – 5 years or so) in the form of regular, recurring (typically monthly) payments.

Given rising costs of inflation and costs of living, many people of all ages, income levels, and backgrounds take out personal loans every year. That said, it’s also important to stay on top of your payments and not get behind if you want to avoid inadvertently dinging your credit score. Thinking of taking out a personal loan? Consider filling out a Rocket Loans℠ application today.

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Scott Steinberg

Hailed as The Master of Innovation by Fortune magazine, and World’s Leading Business Strategist, award-winning professional speaker Scott Steinberg is among today’s best-known trends experts and futurists. He’s the bestselling author of 14 books including Make Change Work for You and FAST >> FORWARD.