Katia Iervasi
Athena Cocoves
A personal loan is money borrowed from a bank, credit union or online lender that you pay back in fixed monthly payments, or instalments, typically over one to seven years.
Though it’s usually best to dip into your savings or emergency fund to cover unexpected expenses, personal loans can be a good option for essential or urgent spending, such as food, housing, taxes or even debt consolidation.
How do personal loans work?
Most personal loans are unsecured, meaning they’re not backed by collateral. Lenders decide whether to give you an unsecured loan based on factors such as your credit score, credit history, debt-to-income ratio and cash flow.
If you don’t qualify for an unsecured loan, you may be offered a secured or co-signed loan. Secured loans are backed by an asset like your home or car, and the lender can repossess your property if you miss multiple payments and default on the loan. Guarantor loans, or co-signed loans, include an additional applicant with a strong credit profile who will help guarantee the loan; they are also responsible for missed payments.
Other types of personal loans include fixed-rate loans, in which your rate and monthly payments stay the same, or variable-rate loans, in which your rate and payments change.
How personal loans affect your credit score
A personal loan affects your credit score much like any other form of credit. On-time payments will build credit, while late payments can damage your score if they’re reported to the credit bureaus.
If you’re in the market for a personal loan, pre-qualifying can give you an idea of the rate and loan amount a lender can offer you without impacting your credit score.
What can I use a personal loan for?
Personal loans can be used for almost any purpose. Common uses include debt consolidation, home improvement projects, medical bills and refinancing an existing loan.
Loans can also be used for other purposes, like paying for a wedding, holiday or other large purchases.
When to use personal loans
A personal loan should help you reach your financial goals rather than contribute to a debt problem, which is why we recommend using one only when it saves you money, improves your income-generating capabilities or helps increase the value of something you own.
For example, a home improvement project could increase the value of your home, and a loan may 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.
A personal loan can also be a smart way to consolidate multiple forms of debt if the loan has a lower interest rate. With this type of loan, you would use it to pay off what you owe, then make fixed monthly payments toward the personal loan.
» MORE: Personal loan vs. car loan
Alternatives to personal loans
For discretionary expenses, consider cheaper alternatives than personal loans.
You might be eligible for a $1,500 loan under the No Interest Loan Scheme (NILS). This is one of the best ways to quickly find the cash you need.
Alternatively, a credit card with a 0% interest rate can be a smart way to borrow money, particularly if you pay the balance back within the card’s introductory period. No interest will be charged on your purchases while your card’s promotional rate is active.
Learn more about the difference between a personal loan and a credit card.
How to get a personal loan
A strong credit profile gives you a better chance of qualifying for a personal loan and getting a lower interest rate. If you have a low score, it’s best to wait before applying so you have time to take steps to improve your credit rating.
Some lenders also prioritise alternative data, or anything not on your credit report, when evaluating applicants, including education, occupation and where you live.
Picking the best personal loan
One of the best ways to evaluate a personal loan is to look at the loan’s interest rate per annum (p.a.). This rate is the total cost of borrowing and includes the interest and any fees.
You’ll want to compare rates from multiple lenders before applying. The loan with the lowest annual percentage rate (APR) is the least expensive and usually the best choice.
Applying for a personal loan
You can usually apply for a personal loan in just a few steps.
First, you’ll want to pre-qualify with multiple lenders to compare offers. Pre-qualifying takes only a few minutes, and you’ll need to provide information like the loan’s purpose, the loan amount, your desired monthly payment and your basic personal details.
After you’ve selected the best offer, you’ll gather documents for the formal application. This usually includes a photo ID, proof of address and proof of employment status, as well as your education history and financial information.
Most lenders now have an entirely online application process, so you can complete your application through a desktop or mobile device.
After you’re approved, you could be funded as early as the same day.
Paying back a personal loan
Personal loans are like any other debt: You should have an understanding of how the monthly payments change your budget and a clear plan to pay off the loan.
This could mean revisiting your budget and adding in your monthly payment, as well as keeping an eye on any refinancing opportunities to take advantage of an even lower rate.
If you’re in the United States, read this article on the NerdWallet US site.
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