Personal Loan: Definition, Types, and How to Get One

What Is a Personal Loan?

A personal loan is an amount of money you borrow to use for a variety of purposes. For instance, you may use a personal loan to consolidate debt, pay for home renovations, or plan a dream wedding. Banks, credit unions, and online lenders can offer personal loans. The money you borrow must be repaid over time, typically with interest. Some personal loan lenders may also charge fees for their loans.

How a Personal Loan Works

A personal loan allows you to borrow a lump sum of money to pay for a variety of expenses and then repay those funds in regular payments, or installments, over time. For example, you might use a personal loan to cover:

• Moving expenses
• Debt consolidation
• Medical bills
• Wedding expenses
• Home renovations or repairs
• Funeral costs
• Vacation costs
• Unexpected expenses

Personal loans are different from other installment loans—such as student loans, car loans, and mortgage loans—that are used to fund specific expenses like education, vehicles, or homes.

A personal loan is also different from a personal line of credit. A line of credit is not a lump sum amount but instead works like a credit card. You have a set credit line that you can spend money against. As you spend, your available credit is reduced. You can then increase available credit by making a payment toward your credit line.

With a personal loan, there’s typically a fixed end date by which the loan will be paid off. A personal line of credit, on the other hand, may remain open and available to you indefinitely as long as your account remains in good standing with your lender.

The Internal Revenue Service (IRS) does not consider a personal loan as part of the borrower's income. The money received on the loan is not taxed. However, if the lender forgives the loan, it is considered a canceled debt, and that amount can be taxed. 

Types of Personal Loans

Personal loans may be secured or unsecured. A secured personal loan requires some type of collateral as a condition of borrowing. For instance, you may secure a personal loan with cash assets, such as a savings account or certificate of deposit (CD), or with a physical asset, such as your car or boat. If you default on the loan, the lender could keep your collateral to satisfy the debt.

An unsecured personal loan requires no collateral to borrow money. Banks, credit unions, and online lenders can offer both secured and unsecured personal loans to qualified borrowers. Banks generally consider the latter to be riskier than the former because there’s no collateral to collect. That can mean paying a higher interest rate for a personal loan.

How a Personal Loan Works

To get a personal loan, you need to apply to a lender. Again, this can be a bank, credit union, or online personal loan lender.

Generally, you would first complete an application. The lender reviews it and decides whether to approve or deny it. If approved, you’ll be given the loan terms, which you can accept or reject. If you agree to them, the next step is finalizing your loan paperwork.

When that’s done, the lender will fund the loan, which means paying you the proceeds. Depending on the lender, these may arrive through a direct deposit into your bank account or a check. After the loan is funded, you can use the money as you see fit. You then have to begin repaying the loan according to the terms established in your loan agreement.

Example of a Personal Loan

When considering a personal loan, it’s helpful to understand how much it may cost. The annual percentage rate (APR) on a personal loan represents the annualized cost of repaying the loan based on the interest rate and fees. The APR and loan term can determine how much you pay in interest total over the life of the loan.

For example, assume you get a $10,000 personal loan with an APR of 7.5%. The loan has a repayment term of 24 months. Using those terms, your monthly payment would be $450 and the total interest paid over the life of the loan would be $799.90.

Now assume you borrow the same amount but with different loan terms. Instead of a two-year term, you have three years to repay the loan, and your interest rate is 6% instead of 7.5%. Using those terms, your monthly payment would drop to $304, but your total interest paid would increase to $951.90.

Comparing the numbers this way is important if you want to get the lowest monthly payment possible or pay the least amount of interest for a personal loan. Using a simple online personal loan calculator can help you determine what kind of payment amount and interest rate are the best fit for your budget.

Where to Find Personal Loans

The first place to look for personal loans may be your current bank or credit union. Your personal banker can advise you on what types of personal loans may be available and the borrowing options for which you’re most likely to qualify.

Personal loans can also be found online. Numerous lenders offer personal loans online. You can apply electronically, get a decision in minutes and, in some cases, get funding in as little as 24 to 48 hours after loan approval.

When comparing personal loans online or off, pay close attention to the details. Specifically, consider the following:

• Interest rate
• Fees
• Repayment terms
• Borrowing limits (minimum and maximum)
• Collateral requirements

It’s also helpful to check the minimum requirements to qualify for a personal loan. Lenders can have different requirements when it comes to the credit score, income, and debt-to-income ratio that are acceptable to be approved for a personal loan. This can help you narrow down the loans that may best fit your credit and financial profile.

The Bottom Line

The wide variety of personal loans currently available makes it almost a guarantee that there's an offer out there suited to your financial needs. However, it's easy to get overwhelmed by the sheer number of options on the market, which may lead you to inadvertently missing out on the most favorable interest rates and loan terms you might qualify for. For this reason, it's crucial to carefully research and compare different lenders and loan products. By taking the time to find the best possible loan, you can keep your monthly payment low while also reducing your risk of default.