How do personal loans work?

Let's say you've always had a goal of putting a pool in the backyard. You've started saving but won't have the amount you need for several more years. Then you see an ad for the pool company's 50th anniversary sale: “For a limited time only, you could have the pool of your dreams at half of the original price! Book your consultation today!”

The problem is that you haven't saved enough, even with the pool at half price.

In this circumstance, a personal loan could be the solution. However, there's more to consider than how quickly you might be able to get the funds you need. With an understanding of how personal loans work compared to other funding options, you can decide which one is best for you and avoid swimming in debt or regret.

Types of personal loans

A personal loan is an agreement between you and your bank or financial institution. They will provide you with requested funds up front and you agree to pay back that amount with interest within a certain period of time.

Personal loans can be an alternative to using a credit card to cover unexpected expenses or one-time, high-dollar purchases. While applying for a personal loan may result in a hard inquiry on your credit, you may still feel like it’s the best decision for your needs.

There are two types of personal loans that you may qualify for, depending on lender requirements.

Unsecured personal loan

An unsecured personal loan means you don't need any collateral in order to qualify. For that reason, if you're unable to maintain repayments, the bank can't directly take your assets. However, failure to repay may result in legal action, wage garnishment, collection efforts or damage to your credit score, which can all affect your financial standing.

Because an unsecured personal loan is a bigger risk for the lender than for the borrower, minimum qualifications to apply for the loan can be higher, such as a better credit score.

Secured personal loan

With this type of personal loan, the bank requires that the customer put up collateral that could be taken away if they aren't able to pay back the loan. Examples of collateral include money in a savings account or a physical asset like a vehicle. If your credit isn't in great shape, you may still qualify for a secured personal loan because the risk involved isn't solely the lender's.

Typically, personal loans have a fixed annual percentage rate, or APR. Factors that can affect APR include the amount of the loan and the length of the loan term. You can get an estimate of your APR and monthly payment by using our personal loan calculator. It can also show you an estimate of how much you'd pay in interest overall.

Budgeting with a personal loan

With a fixed-rate loan, the monthly amount due will be the same until the loan is paid in full. This consistency can make it easier to budget for the length of the term, because there won't be any surprises about what you're expected to pay.

Some lenders may offer personal loans with adjustable interest rates, which means the monthly amount due might change based on market conditions. For example, the variable rate might start out low and manageable before increasing, leading to a bigger monthly expense unless there's an interest-rate cap. If you're not sure you'll be able to keep up with unpredictable payments, this adjustable rate might do you more harm than good.

Reasons for personal loans

In a perfect world, you could save up to cover big expenses and avoid having to go into debt. In the real world, things don't always work out that way. Common uses for personal loans include:

Home repair or remodeling

This can be unexpected and expensive. It's also often time-sensitive, depending on the availability of labor and materials.

Debt consolidation

You could use the personal loan to pay off other debts that may have higher interest rates, such as credit cards or other unsecured loans. This strategy can help reduce the overall number of debts owed and hopefully save you money by putting more toward the principal amount of the debt than you would put toward interest.

Emergency expenses 

You may have unexpected medical bills or need to make a quick, necessary purchase like a new refrigerator when yours goes on the blink.

If you need to take out a loan for emergency expenses, consider building your emergency fund over time to reduce reliance on further borrowing as future emergencies arise.

Comparing personal loans and other options

Depending on the expense, your money management habits and your overall budget, a personal loan could be your best option. But it shouldn't be a financial crutch to lean on for everything. Some personal loans come with additional fees or late payment penalties. Your first step is to review the loan agreement to understand the total cost of borrowing.

From there, explore other options like savings accounts and credit cards. When you consider that the interest rate on a credit card is typically higher than that of a personal loan, using a credit card can easily lead you into further debt. However, if the minimum personal loan you can get is $2,000 and you only need $1,000, a credit card might be the answer.

You might also consider a home equity loan or line of credit, but be sure to understand the terms and conditions including what could happen if you default.

Your goal should be to provide for your project in the cheapest way possible, which means, paying the least amount of interest you can. That's why saving for the expense is usually best. You don't pay interest to anyone when you pay cash. But since that's not always feasible, analyze which option is best for you and has the least impact to your financial security.