What is a personal loan?

A personal loan is money borrowed from a bank, credit union, or online lender that you repay in fixed monthly payments or installments that typically take two to seven years.

While it's often best to tap into your savings or emergency fund to cover unexpected expenses, a personal loan can be a good option for non-discretionary purposes, such as debt consolidation.

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How does a personal loan work?

Most personal loans are unsecured, which means they are not backed by collateral. Lenders decide whether to offer you an unsecured loan based on factors such as your credit score, credit history, debt-to-income ratio, and free cash flow.

If you don't qualify for an unsecured loan, you may get a secured or joint loan. Secured loans are backed by assets such as your home or car, and lenders can repossess your property if you default. A joint loan includes an additional applicant with good credit who will help secure the loan; they are responsible for the unpaid amount.

Other types of personal loans include fixed-rate loans, where your interest rate and monthly payments stay the same, or variable-rate loans, where your interest rate and payments change.

How to choose the best personal loan

One of the best ways to evaluate a personal loan is to look at the loan's APR. APR is the total cost of borrowing, including interest and any fees.

For example, according to NerdWallet's Personal Loan Calculator, if you take out a $10,000 personal loan at 15.5% APR, with a 24-month repayment period and monthly installments of $487, you'll pay a total of $1,694.

Lenders' interest rates can vary from about 6% to an APR of 36%. Before applying, you will need to compare interest rates from multiple lenders. The loan with the lowest APR is the cheapest and usually the best option.

How Personal Loans Affect Your Credit Score

A personal loan affects your credit score like any other form of credit. Paying on time will build credit, and reporting late payments to the credit bureaus could hurt your score.

Applying for a loan can also affect your score. Most lenders allow you to prequalify with a soft pull, which won't hurt your score. Once pre-approved, a formal application triggers a deadlift, usually less than 5 points will be deducted from the score and kept on your credit report for two years.

What can I do with a personal loan?

Personal loans can be used for almost any purpose. Common uses include debt consolidation, home improvement projects, medical bills, and refinancing existing loans.

Loans can also be used for other purposes, such as paying for weddings, vacations, or other large purchases.

When to use a personal loan

A personal loan is supposed to help you achieve your financial goals, not fuel a debt problem, which is why we recommend using a personal loan only if it can save you money, increase your income-generating ability, or help increase the value of something you own.

For example, a home improvement project might increase the value of your home, and a loan might make sense if you don't have a lot of equity in your home or you don't want to use your home as collateral.

Alternatives to Personal Loans

For discretionary fees, consider cheaper alternatives than a personal loan.

A 0% APR credit card can be one of the best ways to borrow money, especially if you pay off the balance within the introductory period of the card. This period can be up to 21 months and no interest will be charged on your purchases.

You need good credit - above 690 FICO - to be eligible for the 0% card.

A personal line of credit is another option. These are usually offered by credit unions and banks and are a mix of loans and credit cards. Like a loan, the lender needs to approve your application, but like a credit card, you only withdraw the amount you need and only pay interest on the amount you use.

A line of credit is ideal for borrowers who are uncertain about their total borrowing needs. Those with good or excellent credit are most likely to be approved with the lowest interest rates.

How do I get a personal loan?

A good credit profile gives you a better chance of getting a personal loan and getting a lower interest rate. However, some lenders offer fair credit and bad credit loans.

Some lenders also prioritize alternative data or any data not on your credit report, including education, occupation, and where you live, when evaluating applicants.

Apply for a personal loan

You can usually apply for a personal loan in just a few steps.

First, you need to prequalify with multiple lenders to compare quotes. Pre-qualification takes only a few minutes and you will need to provide information such as loan purpose, loan amount, required monthly repayments and basic personal details.

After selecting the best offer, you will collect the documents for the official application. This typically includes photo ID, proof of address, proof of employment status, educational history, financial information, and your Social Security number.

Most lenders now have a fully online app, so you can complete your application from your desktop or mobile device.

Once approved, you can receive funds as early as the same day.

repay personal loan

A personal loan is like any other debt: you should understand how monthly payments can change your budget and have a clear loan repayment plan.

This could mean reviewing your budget and increasing your monthly payments, as well as keeping an eye on any refinancing opportunities to take advantage of lower rates.

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