How Do Personal Loans Work?

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Personal loans are surprisingly popular. More than 20 million consumers have one, with an average debt of $8,402 per borrower. 

It’s not hard to see why. In good times, the personal loan can be used to fund basically any expense, including home repairs, launching a business, or even wedding and funeral costs. In tough times, they’re used to tackle credit card debt by consumers who can get a lower interest rate on a loan than what their card issuers are charging.  

But with many Americans facing unexpected job loss and reduced income in 2020, any rise in demand could run into a personal loan market that’s contracting as banks and lenders look to minimize their exposure heading into a likely recession.

So financial experts say you need to weigh your options more carefully than ever when considering a personal loan. While lower interest rates could make a personal loan more attractive, you’ll have to demonstrate a sterling credit history before locking in those advertised rates.

Pro Tip

Personal loans offer versatility when you need cash for an emergency or major planned expense, but keep in mind that your interest rate will depend on your creditworthiness.

Anuj Nayar, financial health officer of LendingClub, said LendingClub has paused customer acquisition marketing and focused efforts on existing customers, to whom they’re offering payment deferments in the case of financial hardship. As for new applicants, underwriting requirements have become more stringent. LendingClub is now asking for more verification and pulling back on the types of loans offered to people with average-level credit.

Other major banks and online lenders we reached out to would not comment on loan application volume since the COVID-19 pandemic started, though some are offering reprieve to existing customers. U.S. Bank, for example, is offering a temporary rate reduction (fixed 2.99% APR) for existing unsecured personal loans under $5,000 with terms up to 48 months, according to a spokesperson. 

As always, the choice to get a loan is highly dependent on your life goals, financial history, other debt levels, and personal risk tolerance. There are steps and precautions you should take before signing on the dotted line, lest you get trapped into monthly payments you can’t afford. 

We asked Nayar and Farnoosh Torabi, financial journalist and host of the ”So Money” podcast, for their insider tips on personal loans.

What You Should Know About Personal Loans

Personal loans are known for their versatility and flexibility. They can be used for consolidating credit card debt, launching small businesses, implementing home repairs, refinancing student loans, funding vacations, and a number of other expenses — both necessary and discretionary. 

The way it works: You borrow money at a fixed interest rate for a fixed period of time, and you pay it off with a fixed monthly payment. Most personal loans are unsecured, meaning they don’t require collateral, such as your house or car, for loan approval.

Potentially lower interest rates, combined with fixed payment terms, can make personal loans more attractive than credit cards. “If you’ve got multiple credit cards that are all over 20% interest, and you can get a personal loan at 10%, then a lot of times I see people using that loan to save money on interest,” Torabi explains.

The terms of personal loans can vary based on your creditworthiness. To get the best interest rate, you will need to have a good to excellent credit score and a strong credit history that shows lenders that you will not be a risky investment for them.


Potentially low interest rate: Depending on your creditworthiness, the rate you receive on a personal loan may be half or a third of a credit card’s APR.

Flexible uses: While many of these uses may not be recommended, loans can technically be used to cover any number of expenses, including weddings, vacations, divorces, funerals, student loans, home improvement projects, medical bills, small business launches, and credit card debt.

Fixed terms: Generally, the terms of a personal loan will be simple and straightforward. Your interest rate, term length, and monthly payment amounts will be fixed and not subject to the whims of the market. 

Unsecured: Most personal loans do not require you to put up collateral, like your car or house, as a requirement for loan approval. 

Big lending market: You don’t necessarily have to go to a traditional brick-and-mortar to secure a loan. Community banks, online banks, credit unions, and lending startups are also options — and rates may even be better because of lower overhead costs.


Hidden fees: When shopping and negotiating for a personal loan, it’s important to inquire about origination fees (one-time fees between 1% to 8% of the loan amount) and prepayment penalties (fees incurred for paying off a loan early). Otherwise, the loan that looks good on paper may end up costing you more in the long run.

Requires good credit: If you have poor credit history, or no credit history, then it may be difficult for you to procure a personal loan, much less one with an agreeable interest rate. The better credit history you have, the better APR you’ll get.

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