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What is a Personal Loan and How Does it Work?

7 minute read Woman and man sitting at a desk in an office looking at a laptop doing research for best personal loans.

Disclaimer: Upstart is not a financial advisor, the following content is for informational purposes only.

If you’re trying to decide if a personal loan is right for you, you may be wondering how they work, when it’s a good idea to get one, and what you’ll need to do to qualify. We’re here to help answer those questions and guide you with information about personal loans and how they could be right for you.

Personal loans definition

In the simplest terms, a personal loan is money you borrow from a financial institution, online lender, or lending platform. They are also known as debt consolidation loans, installment loans, or signature loans. You’ll need to pay back the loan plus interest over a specific payment period. 

One of the most appealing aspects of a personal loan is that lenders can usually provide funds in 7 – 10 business days and, sometimes, in as little as 24 hours.

Personal loan lingo

Learning about loans for the first time can be confusing, but learning the language of loans can help you feel more confident about making big financial decisions. We’ve outlined the most common loan terms to help you understand how personal loans work:

  • Loan application: A loan application is a document you need to fill out (typically online) if you’re interested in applying for a loan from a lender or an online lending platform. The application helps lenders determine if you’re financially healthy enough to get a loan and if you are, the loan terms you prequalify for.
  • Loan term: A loan term is the amount of time you’ll have to pay back the lender for the loan. A longer loan term might sound like the best option since it can help reduce the amount of your monthly payment, but there’s a catch—longer loan terms likely increase your interest rate. Paying a higher interest rate over a longer term means you’ll end up paying more over the life of the loan.
  • Fees: Taking out a loan isn’t free. Depending on the lender you work with and the type of loan you’re taking out, you may need to pay additional costs to borrow money. Some of these fees can include a loan origination fee, which lenders add to your balance from the start. Another is an annual fee that can be added to your balance each year. Also, if you pay off your loan before it’s due, the lender could charge you a prepayment penalty.
  • Annual percentage rate (APR): When you see advertisements for loans, you’ll usually see the APR listed too. It’s essential that you understand what your APR is since it’ll give you an idea of how much your loan will cost over time. The APR is usually shown as a percentage and includes the yearly cost of both the interest and the fees on the loan.
  • Interest/interest rate: Similar to the APR, an interest rate is typically shown as a percentage. Since lenders don’t give out money for free, they charge a portion of the loan amount, which you pay to the lender each month for being able to borrow from them.
  • Principal: The principal is the amount of money you borrow from your lender before interest is added.
  • Monthly payment: A monthly payment is the amount that you, the borrower, will be required to pay to the lender each month until your loan has been completely paid off. Each payment includes a chunk of the principal plus the interest that has accumulated for that month.

Secured vs. unsecured loans 

There are two primary types of personal loans: unsecured loans and secured loans. The main difference between these types of loans is collateral.

To get a secured loan, you’ll need to pledge collateral. Secured loans are an option commonly offered to borrowers who are considered a higher risk. Collateral is a personal item of great value  (i.e., assets like cars, boats, homes, etc.) that a borrower agrees to put down in order to back up the loan. If the borrower can’t repay the loan (called a default) or can’t meet the terms of the loan, the lender can take the asset to recoup their loss. 

If you can pledge collateral upfront and add it to the agreement, your interest rate may likely be lower, your loan limits higher, and your repayment period longer.

Unsecured loans, on the other hand, don’t require collateral. These types of loans typically have a higher interest rate, but a shorter repayment period. 

If you’re struggling financially, an unsecured loan could be harder for you to get, since the lender may think you won’t be able to repay the loan, which makes you a higher risk borrower. 

What is the benefit of obtaining a personal loan?

Personal loans are flexible and you can use them for almost anything. While you might want to take out a personal loan and treat yourself to a spending spree or invest in your friend’s new business, it doesn’t mean you should. Let’s look at some financially strategic purposes for a personal loan.

In general, it’s often smart to take out a personal loan when it can improve your financial situation or provide quick and essential funds. Thinking strategically about taking out a personal loan is important since you’ll need to pay it back (with interest).

  • Unexpected expenses: Ideally, you’d have money tucked away in your savings account for any major emergencies, but life isn’t always predictable. A personal loan can help if you need financial assistance if you lose your job, your car breaks down, or you have to pay off medical bills.
  • Big personal events: Sometimes expensive life events like weddings, divorces, or funerals crop up. A personal loan can financially help for important events like these at the right time. 
  • Home improvements: If you’ve been wanting to make some home improvements, consider using a personal loan. Why? Other popular alternatives like a home equity loan or line of credit can require you to use your home as collateral. If you default on the loan, the lender can claim your home to make up for the payments you missed. A personal loan sidesteps that possibility and you can still get your dream kitchen. 

While most personal loans can be used for almost anything, some lenders may have restrictions on how you can use the money. Check with the lender you’re considering before you make that commitment to make sure you can use your loan for what you need. 

How to qualify for a personal loan

Lenders want to be confident that you’ll be able to pay back a loan completely and on time before they give it to you. To decide if you’re a good risk, lenders will consider several key factors from your loan application. Here’s a short list of what they look at.

  • Credit report: A credit report is essentially a record of how well you’ve paid past debts. It’s like a report card or a financial transcript. Lenders typically review these reports to help them decide who to grant loans to and on what terms. If a lender sees too many red flags, like delinquent payments, collection accounts, bankruptcy, and foreclosure, they may choose to deny you a loan. 

Did you know? You’re entitled to a free annual credit report from each of the three major credit reporting agencies: Equifax®, Experian™, and TransUnion®. To get your free reports, go to AnnualCreditReport.com or call 1-877-322-8228.

  • Credit score: A credit score is a snapshot of your overall credit history (think: a record of how well you’ve paid past debts) that your lender uses to determine your creditworthiness. Just like getting an A is a good sign that you did well on your science test, having a high credit score is a fast way for lenders to see that you have a great history of using credit responsibly. If your lender considers you creditworthy, then you may have a better chance of getting approved for a loan with a low interest rate. Here’s a handy table that shows how Experian ranks credit scores:

 

TYPE OF CREDIT SCORE SCORE RANGE
Excellent 800 – 850+
Very good  740 – 799
Good  670 – 739
Fair  580 – 669
Bad  300 – 579
  • Income: Even if you have a good credit score and report, lenders still need proof that you have enough funds to pay back the loan. To get this proof, they will carefully consider your debt-to-income (DTI) ratio. This ratio is the percentage of your total monthly income (before taxes) that goes toward debt payments. A low ratio indicates to lenders that you’ll be able to afford your loan payments since you will likely have money left over after paying your current debts.

Pro tip: You can calculate your DTI by adding up your monthly debt (including credit cards, auto loan, student loan, etc.), and divide it by your total monthly income. Just convert the decimal result into a percentage to get your DTI.

It’s essential that you make sure you’re financially healthy enough to pay your monthly loan payments in full and on time. If you default on a personal loan, it could significantly damage your credit score, which could take a lot of time to improve. Additionally, as we mentioned earlier, if you have a secured loan, you could lose your collateral or your lender could sue you to recover the debt.

What if I don’t qualify for a loan?

If you don’t think you’re financially healthy enough to go through the personal loan application process yet, work on improving your credit and income situation before you apply. Check your credit report to identify areas that you need to address and work on paying down debt to reduce your DTI. 

This process can take time. If you need a solution quickly, you still have options. If you’re not eligible for an unsecured loan, you could get a secured loan designed for borrowers with bad credit, or you could get a co-signed loan. 

If you decide to opt for a secured loan, be aware that the interest rates will likely be high. Your other possible option, a co-signed loan, will require you to get a family member or friend with strong credit to help guarantee the loan. If you miss any payments, the lender will hold the co-signer responsible. 

Like a secured loan, a co-signed loan also typically comes with a high interest rate since lenders consider these to be a higher risk loan.

Should I get a personal loan? This might be the perfect time 

Only you can answer that question, but we can tell you that if you’re thinking about it, you may want to do it sooner rather than later. Why? Federal Reserve officials have signaled that they are likely to raise interest rates as soon as March 2022 because of rising inflation. If you opt to get a personal loan now, you’ll probably be able to save money. 

Remember, knowledge truly is power. Before signing on the dotted line, make sure that you understand exactly how your loan works, what your monthly payment will be, and how long it’ll take you to pay it off.



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