Personal Loans: What They Are, How They Work, and How to Choose

What Is a Personal Loan?

A personal loan is a type of installment credit that provides a lump sum of money, which you repay in fixed monthly payments over a set term. This structure makes budgeting predictable, as your payment amount stays the same each month. Personal loans are typically used for a wide range of purposes, from consolidating debt to funding a major purchase or covering unexpected expenses.

The personal loan market is substantial. As of the end of 2022, outstanding personal loans in the U.S. reached $356 billion, accounting for about 10% of nonrevolving consumer credit. This popularity reflects the flexibility and accessibility of personal loans for many consumers.

Sources: Federal Reserve Board, PNC, Investopedia

Secured vs. Unsecured Personal Loans

Personal loans generally come in two forms: secured and unsecured. A secured loan is backed by collateral, such as a car or savings account, which the lender can seize if you default. An unsecured loan does not require collateral, so the lender relies on your creditworthiness to determine approval and terms.

Most personal loans are unsecured. This means you don't have to put up an asset, but lenders will scrutinize your credit score and financial history more closely because they have less security. Understanding this distinction is fundamental when comparing loan options.

Sources: Federal Reserve Board, PNC, U.S. Bank, Investopedia

Types of Personal Loans

Beyond the basic secured/unsecured split, personal loans are often categorized by their purpose. Common types include debt consolidation loans, which combine multiple debts into one payment; home improvement loans, designed for renovation projects; and medical loans, which help cover healthcare costs. These loans may come from banks, credit unions, online lenders, or fintech companies.

Another type is a co-signed personal loan, where a second person, the co-signer, applies jointly with the borrower and shares legal responsibility for repayment. A co-signer with a stronger credit profile can help a borrower with limited credit history qualify for a loan or receive a better rate. However, both parties are responsible for the debt, and late or missed payments can affect the credit scores of both. Lenders disclose the terms and responsibilities of co-signed loans in the loan agreement.

It's also important to note that not all uses are allowed. Personal loan funds generally cannot be used for post-secondary educational expenses or as a down payment on real estate. Lenders specify what you can and cannot use the funds for, so always read the terms carefully.

• Debt consolidation loans: combine multiple debts into one loan with a single monthly payment, often at a lower interest rate.
• Home improvement loans: fund repairs, renovations, or upgrades to your home.
• Medical loans: cover medical procedures, dental work, or other healthcare costs.
• Major purchases: finance large items like appliances, furniture, or a wedding.
• Unexpected expenses: provide funds for emergencies such as car repairs or medical bills.
• Co-signed loans: include a co-signer who shares repayment responsibility, which may help borrowers with limited credit qualify.

Sources: PNC, U.S. Bank, OneMain Financial

Interest Rates, Fees, and How to Compare Offers

The annual percentage rate (APR) on a personal loan represents the total yearly cost of borrowing, including interest and any required fees, such as origination fees. Lenders may also charge late fees if you miss a payment. Because APRs can vary widely based on your credit profile, market conditions, and the lender, it's essential to compare offers from multiple sources.

APRs can be fixed, meaning the rate stays the same throughout the loan term, or variable, meaning the rate can change over time. Most personal loans have fixed rates, which give you predictable monthly payments.

To compare offers effectively, look beyond the monthly payment and consider the APR, any fees, and the total cost over the life of the loan. Prequalification tools let you see potential rates with a soft credit inquiry, which does not affect your credit score. This allows you to shop around without hurting your credit.

• APR includes interest and required fees, giving you a fuller picture of the loan's cost.
• Fixed-rate loans keep your interest rate constant, while variable rates may fluctuate.
• Prequalification typically uses a soft inquiry and won't impact your credit score.
• Compare offers side-by-side, paying attention to the APR, total cost, and any fees.

Sources: PNC, Investopedia, Experian

Factors That Affect Loan Terms and Approval

When you apply for a personal loan, lenders assess your creditworthiness to decide whether to approve you and what interest rate to offer. The most influential factor is your credit score, but lenders also look at your credit history and your debt-to-income ratio, which is the percentage of your monthly income that goes toward debt payments.

A higher credit score generally leads to better loan terms, such as lower APRs and higher borrowing limits. Conversely, a lower score may result in higher rates or denial. Understanding these factors can help you improve your chances of approval and securing a favorable rate.

• Credit score: a numerical representation of your credit risk, based on your credit history.
• Credit history: a detailed record of your borrowing and repayment behavior.
• Debt-to-income ratio: your monthly debt payments divided by your gross monthly income, used to gauge your ability to repay.

Sources: PNC, Investopedia

Steps to Getting a Personal Loan

The process of obtaining a personal loan is straightforward, but it pays to be thorough. By following a systematic approach, you can increase your chances of getting a loan that fits your needs and budget.

1. Assess your borrowing needs and budget.
2. Check your credit score and report.
3. Shop around and prequalify with multiple lenders.
4. Choose a loan offer and submit a formal application.
5. Review the terms and sign the loan agreement.
6. Receive your funds and start making on-time payments.

Sources: OneMain Financial, Investopedia, Experian

Evaluating Lenders and Avoiding Predatory Offers

When comparing personal loan offers, it's essential to evaluate each lender carefully. Look for transparent terms, reasonable APRs, and clear fee structures. Some lenders may advertise a low rate but add high origination fees or other charges, so read the fine print.

Be cautious of predatory lenders who may charge exorbitant interest rates or target financially vulnerable consumers. While federal regulations provide some protections, state laws vary significantly. To protect yourself, work with reputable lenders, understand all costs before signing, and never agree to terms you don't fully comprehend.

Sources: Federal Reserve Board, Investopedia

Alternatives to Personal Loans

While personal loans are a versatile borrowing option, they aren't the only choice. Depending on your situation, you might consider alternatives such as credit cards, home equity loans or lines of credit, or borrowing from friends or family. Each option has its own costs and benefits.

Credit cards can be useful for smaller expenses, but they often carry higher interest rates if you don't pay the balance in full. Home equity loans typically offer lower rates but require collateral and may have stricter approval requirements. Friends or family loans can avoid interest but can strain relationships if not managed carefully.

Before committing to any loan, evaluate your financial situation, compare costs, and determine which option aligns best with your long-term goals.

• Credit cards: flexible for small amounts, but can have high interest rates.
• Home equity loans or lines of credit: often have lower rates, but use your home as collateral.
• Borrowing from friends or family: may be interest-free, but can affect personal relationships.

Sources: PNC, U.S. Bank, Investopedia

Key Statistics and Market Insights

The personal loan market has grown significantly, with fintech lenders playing an increasingly important role. According to the Federal Reserve, about $50 billion of personal loans were issued by fintech companies in 2022, representing 14% of total personal loans. This reflects the rise of online lending platforms that offer streamlined applications and quick approvals.

The market is also highly active, as evidenced by over 1.4 billion unsecured personal loan offers sent to U.S. consumers in 2022. Fintech lenders accounted for 35% of these offers, while banks sent 26%. This competition can be beneficial for borrowers, as it may lead to more favorable terms.

For context on individual borrowing, as of the end of 2022, the median personal loan account balance was $4,198, and the median monthly payment was $202. These figures offer a snapshot of typical borrowing patterns, though amounts vary widely.

Sources: Federal Reserve Board

Regulatory Considerations

Personal loans are subject to a complex regulatory environment that blends state and federal oversight. In the U.S., states regulate personal loans through interest rate ceilings, which cap the maximum rate lenders can charge. Some states have high or no interest rate ceilings, while others have stricter limits.

Credit unions, for example, are subject to an 18% interest rate ceiling for traditional personal loans, imposed by the National Credit Union Administration. However, they can make payday alternative loans at rates up to 28%. Understanding the regulatory framework can help you gauge the fairness of an offer and know where to seek recourse if a lender acts improperly.

Sources: Federal Reserve Board