What Is a Personal Loan and How Does It Work?

If you're looking to borrow money—whether it's to make a large consumer purchase, start a business, or get out of debt—credit cards and home equity loans are not your only options. Personal loans are another tool used by older adults to get the funds they need to reach their goals.

Before taking out a personal loan, however, it's important to know what you're getting yourself into. Understanding the pros and cons of this financial product can help you decide if it’s the right choice for you.

What is a personal loan and how does it work?

A personal loan is a versatile type of loan you can get from a bank, credit union, or online lender. When you apply for a personal loan, you'll request a specific amount of money you want to borrow. If approved, you'll receive the full amount in a lump sum—typically within a few days (or even sooner). In general, personal loans:

• Come with fixed interest rates (meaning the rate stays constant throughout the loan's term)
• Have predictable monthly payments
• Have a fixed repayment period, anywhere from one to five years
• Range in amounts from $1,000 to $50,000

In addition to interest, some personal loan lenders charge origination fees and other types of fees to cover loan processing costs. These extra charges, which usually range from 1% to 8% of the total loan amount, can greatly increase your overall borrowing costs. You may also incur fees if you make late payments or pay off your loan early.

Most, but not all, personal loans are unsecured loans. This means that unlike secured loans (e.g., auto loans and mortgages), they are not backed by any type of collateral such as a car or home. Instead, personal loans are approved based on your credit history, income, and other financial factors.

What is a personal loan used for?

With some exceptions (e.g., college tuition costs), you can use your personal loan money however you see fit. Personal loans are used for a variety of purposes, such as credit card debt consolidation, medical expenses, and home renovations. Other common uses for personal loans include car purchases, moving expenses, and legal fees.

Although you can take out a personal loan for virtually any reason, that doesn't mean you should. According to the credit reporting agency Experian, the best uses for a personal loan include:

• Emergencies, such as medical expenses from a serious car accident or illness
• Home renovations that increase the value of your home and improve your financial situation
• Major life events, such as a wedding or funeral, if you don't have the cash on hand
• Debt consolidation if you have several high-interest credit card balances

For non-essential expenses, like a luxury vacation or high-end home furnishings, it's best to save up your money and pay in cash. That way, you won’t have to pay extra interest on top of the expense itself.

What do I need to get a personal loan?

The requirements for getting a personal loan can vary depending on the lender, loan amount, and other factors. In general, here are some of the main things lenders look at when determining loan eligibility.

1. Credit score. Your credit score is a key factor lenders consider when reviewing your loan application. While some lenders accept a wide range of credit scores, many want applicants to have a minimum score of around 600. They will also pull your credit history to make sure you have a track record of paying your bills.
2. Income. Lenders want to know you have a steady, established source of income to repay the loan. Income requirements differ from lender to lender. You'll likely be required to provide proof of income in the form of recent pay stubs, tax returns, W-2 forms, and/or bank statements.
3. Debt-to-income ratio (DTI). Some lenders may consider what's called your debt-to-income ratio (or DTI). This is the ratio of your monthly debt payments to your monthly income. This helps them assess your ability to handle additional debt. Generally, a DTI of 36% or less is the target, although lenders may have different guidelines.
4. Collateral (if applicable). Some personal loan products are secured loans. If you’re applying for a secured personal loan, you'll need to provide information about your collateral. Collateral can be in the form of bank savings accounts, investment accounts, real estate, and other valuable assets.

What factors should you consider before choosing a personal loan?

Here are some things to keep in mind when exploring personal loan products:

1. Interest rate: This is one of the biggest factors affecting the overall cost of the loan. A lower interest rate will result in lower monthly payments and less money paid in interest over the life of the loan. Compare interest rates from different lenders to find the most competitive one. Personal loan rates typically range from 6% all the way up to 36%.
2. Added fees: Be aware of any upfront fees, processing fees, origination fees, prepayment penalties, and other charges tied to the loan. These can inflate your overall cost of borrowing.
3. Total loan cost: Calculate the total amount you’ll repay over the life of the loan, including the principal, interest, and fees. This will give you a clear picture of the loan's overall cost.
4. Funding timeframe: When will you get your money? If you need cash quickly, look for lenders with fast approval timelines and same-day or next-day funding.
5. Monthly payment amount: Make sure the monthly payment fits your budget comfortably. You should be able to make the payments without straining your finances.
6. Repayment period: Consider the loan's repayment period or term. A shorter term means higher monthly payments but lower total interest costs. A longer loan term will have lower monthly payments but could cost you much more in interest.
7. Flexibility: Look for lenders that offer repayment flexibility, such as the option to change the due date or temporarily defer payments in case of financial hardship.
8. Lender reputation: Not all lenders are trustworthy. Before signing on the dotted line, research the lender's reputation and check out customer reviews. A lender with a solid history of happy customers is more likely to deliver a positive borrowing experience.

Personal loans aren’t for everyone, says Darren Hotton, NCOA's Associate Director of Community Health and Benefits. But if you’re considering this option, shop around to find the very best rate and terms.

Take the time to carefully compare different lenders and products,” Hotton explains. “Do the math and read the fine print. That will allow you to decide if the financial benefits of a loan outweigh the risks.”

Want to improve your financial security as you age?

• Use NCOA's Budget CheckUp and learn how you can build a plan to better manage your finances, including finding ideas for financial planning, how to earn extra income, and ways to use prepaid cards wisely.
• Visit our Debt for Older Adults resource page to learn how to manage personal loan debt and other types of debt.
• Browse our Money for Older Adults resource page to make the most of your money as you grow older.
• Explore NCOA’s BenefitsCheckUp to see how you can save money on groceries, utilities, taxes, health care, and more.