Father learning about personal loans with baby next to him
Financial Literacy
4 minute read

Personal loans are a significant component of financial planning and management. But you may still be wondering, “What is a personal loan?” This Personal Loan 101 is designed to help you understand the basics of personal loans, how they function, their benefits, and how you can qualify for one.

Definition of a personal loan

A personal loan is a form of credit provided by a lender that borrowers can use for multiple purposes. It’s a fixed sum of money you repay in equal installments over a predetermined period. Personal loans can be used to consolidate debt, cover medical costs, pay for home improvements, or practically anything else you need cash to cover.

The mechanics of personal loans

Unlike credit cards, personal loans have a set repayment schedule, providing you with a precise payoff term. Once you borrow the money, you can’t access additional funds by making payments, as you might with a credit card. The fixed payment schedule means you can accurately anticipate when your loan will be fully repaid and plan your finances accordingly

Secured vs. unsecured loans

Personal loans can be either secured or unsecured:

  • Secured loans require collateral such as a house or car. If you default, you risk losing the asset. However, secured loans usually have lower interest rates because the lender has a form of security in the event of default.
  • Unsecured loans do not require collateral. If you default, your credit score may take a hit, but no physical asset is at risk. However, unsecured loans typically come with higher interest rates due to the increased risk to the lender.

consolidate debt, pay down high-interest rate credit cards, take on a home improvement project, or do nearly anything else you can put your mind to.

Benefits of personal loans

When managed responsibly, a personal loan can offer several benefits:

  • Simplification of finances: Consolidating various payments into a single recurring payment can simplify your financial management.
  • Savings: Using a low-interest personal loan to consolidate high-interest credit card debt could save you money in the long run.
  • Adding financial value: You can use a personal loan to make home improvements, potentially increasing your property’s value.
  • Stress relief: In times of sudden financial need, a personal loan can help make a challenging situation more manageable.
  • Credit score enhancement: A well-managed personal loan can improve your credit score by diversifying your credit mix and demonstrating a good payment history.

Potential costs of personal loans

The cost of a personal loan can vary. Your credit score and the lender’s terms play a significant role in determining your interest rate. A better credit score increases your chances of securing a loan at a lower interest rate. It’s always wise to compare loan rates before deciding on a lender.

Amount you can borrow

The amount you can borrow with a personal loan largely depends on your credit history, income, and the lender’s policies. Lenders may offer a range of loan amounts from small to quite large, but it’s crucial only to borrow what you genuinely need to avoid unnecessary debt.

Getting approved for a personal loan

The approval process for a personal loan is unique to each lender. The criteria generally includes having a good credit history, a record of on-time repayment, and a low debt-to-income ratio that indicates your income can sufficiently cover your debt. Some lenders may approve loans to borrowers who pose a higher risk, but those typically come with higher interest rates. Keep in mind, it may take some time to be approved. Take that into consideration if you need the funds in a hurry. However, when you’re approved, your funds typically don’t take long be available to you. Once the funds are in your account, you can use them to cover your financial needs.

Conclusion

Understanding personal loans can help you make informed financial decisions. Whether you’re consolidating debts, covering unexpected expenses, or investing in home improvements, a personal loan can be a helpful financial tool when used responsibly. Always consider your financial situation and consult with a professional before making significant financial decisions.

This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.

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