How Personal Loans Work

A personal loan can give you the funds you need for a variety of reasons, such as paying for home repairs or debt consolidation. But before you apply, learn all about how these loans work and consider whether they’re the right choice for you.

How personal loans work

When you take out a personal loan, you receive a lump sum of money that you have to pay back over a fixed term. You usually have a set monthly payment and interest rate, although those can vary depending on your lender, creditworthiness and what kind of loan you get. You may also have to pay a fee or penalty for late payments, which can add up quickly.

The amount you borrow, term length and repayment terms are all spelled out in the loan agreement that your lender sends to you once you’re approved. The agreement will detail what you need to do, including making monthly payments on time. It will also explain the interest rate, how much you owe and when your loan must be paid off by. It’s a good idea to read your agreement carefully, because it will likely affect your credit scores and other financial decisions.

You can get a personal loan from banks, credit unions, peer-to-peer lenders and other types of online lenders. Each lender sets its own qualifications for loan approval, but most require a credit score of at least 580, proof of income and the ability to repay the debt. You may also have to submit an application and undergo a full review of your financial history, which can include a hard credit inquiry.

If you have a poor credit score, you’re likely to have a more difficult time getting a personal loan, and your lender might require you to have a co-signer to increase your chances of approval or offer lower interest rates. However, there are steps you can take to improve your credit before applying for a personal loan so you can qualify for the best rates and terms.

How personal loans affect your credit

If your application for a personal loan goes through, you will most likely be subject to a hard credit inquiry, which can cause a small dip in your credit score. However, if you use the funds for a responsible purpose and make your payments on time, a personal loan can actually help your credit by diversifying your borrowing mix and lowering your credit utilization, as long as you’re careful not to max out your credit cards.

If you’re weighing your options for a personal loan, consider factors like approval speed and funding time, whether there are fees associated with applying and paying back the loan and customer experience. And don’t forget that other types of credit can be better alternatives for discretionary expenses, such as a 0% interest credit card, which will let you pay off your balance without incurring any interest charges if you pay back the principal within the promotional period.

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