How Personal Loans Work

Personal loans are offered by banks, credit unions, and private financial institutions. You can take a personal loan of anywhere from a few hundred dollars to thousands of dollars. The funds that you receive can be used for just about any purpose. 

When applying for a personal loan, you may be required to state what you need the funds for. However, the purpose of the funds rarely has a bearing on whether or not you get approved. Being approved depends majorly on how the lender assesses your risk.

Different lenders have different eligibility criteria for the approval of personal loans. Fortunately, these criteria are generally quite easy to meet.

Once approved, lenders rarely place restrictions regarding what you can spend the funds on. Their primary and only concern is that you make those repayments on time. In most cases, you will have between one and five years to repay the loan. 

Types of Personal Loans & The Pros & Cons of Each

There are 7 main types of personal loans available, each of which has its own pros and cons.

1. Unsecured Personal Loans

Unsecured personal loans are loans that are offered without any collateral. That means the lender lends you money without asking you to put anything up as collateral. 

Lenders will approve your unsecured personal loan application based on your credit score. A good credit score will make it easier to get approved as it shows that you’re a creditworthy borrower. This makes it more likely that you’ll pay the loan back on time. Because there is no collateral involved, these loans are riskier for lenders. They offset this high risk by imposing higher interest rates on unsecured loans.

Pro:

• You don’t have to put up your home, car or any other asset as collateral.
• You can use the funds for any purpose you need to without restrictions.

Con: 

• You must have a good credit score and steady income to get approved. It’s difficult to get approved if you don’t meet these two requirements. 
• You pay a slightly higher rate of interest on the loan.

2. Secured Personal Loans

Secured personal loans are backed by collateral. That means you will have to put up some assets to take out this type of loan. 

Lenders offer unsecured personal loans against your vehicle, personal savings, or any other valuable asset. If you default on your loan, the lender can seize whatever asset you’ve put up as collateral.  Because the risk is lower, you will have a lower interest rate on these loans.

Pros: 

• This type of loan is easier to get because you’re putting up a valuable asset as collateral. You don’t need to worry about your credit score. 
• Potentially lower rate of interest. Putting up collateral makes you a less risky borrower, which qualifies you for a lower interest rate. 
• You may also get approved for a larger loan depending on the value of the collateral.

Cons: 

• You could lose your collateral if you do not repay the loan on time. 

3. Fixed-Rate Loans

With fixed-rate loans, your interest rate and monthly payments stay the same throughout the life of the loan. When you choose this type of personal loan, the interest rate is fixed at the time of taking the loan. The lender calculates the total payment over the full loan term. This includes the principal and the accrued interest. The total amount is divided into equal monthly payments over the loan term. These remain unchanged every month till the debt is completely paid back. 

Pros: 

• Consistent monthly payments mean you know exactly how much you need to pay every month. This doesn’t change over the loan term, making it easier to create and stick to a monthly budget. It also makes it easier to set long-term financial goals. 
• Rising interest rates won’t affect you. A fixed interest rate means your payments are not subject to market movements. You never have to worry that your monthly repayment amount may increase. 

Cons: 

• You won’t benefit in the rare event that interest rates fall. While it’s great that you don’t pay higher interest rates when market rates increase, it also means you can’t get a lower rate. 
• Fixed interest rates tend to be higher than variable interest rates. And because you’ll be paying the same rate throughout, you could potentially pay much more in accrued interest. 

4. Variable-Rate Loans

With variable-rate loans, the interest rate fluctuates depending on prevailing market conditions. The rate could increase in a strong market or drop in a weak market. When rates increase so will your monthly payment. When rates drop, your monthly payments will drop too. 

There’s no way to predict whether interest rates will increase or drop over the loan term. However, there is usually a cap on how much the rate can change over a specified period of time. These loans usually have a lower APR as compared to fixed-rate loans.  

Pros: 

• Variable-rate loans usually have lower interest rates as compared to fixed-rate loans. Even if rates stay the same over the loan term, you’ll still pay less interest than a fixed-rate loan. 
• The interest rate could drop considerably if overall market interest rates drop. This could potentially save you thousands of dollars in accrued interest. 

Cons:

– The interest rates and monthly payments fluctuate frequently with this type of loan. These fluctuations can make it difficult to set or adhere to a budget. 

– You may pay a higher rate if market interest rates rise. This will increase your monthly payments as well as the total cost of the loan. 

5. Cosigned Loans

A high credit score is a basic requirement to get approved for an unsecured loan. Even if you do get approved for this type of loan, the lender will almost certainly quote a higher interest rate. This could increase the cost of the loan substantially. One way to work around this is by applying for a loan with a cosigner.  

A cosigner is someone who is creditworthy. In other words, they meet the lender’s eligibility criteria. When you apply for a cosigned loan, the lender will approve your application based on your cosigner’s credentials. Both names, yours and the cosigners, are put on the loan agreement and both are equally responsible for the payments. That means if you default on your payments, your cosigner will be held responsible to pay up. 

Pros:

• If you don’t meet the lender’s borrowing requirements, taking a cosigned loan can help you get the funds you need.
• Taking a cosigned loan can also help to boost your credit score provided that all payments are made on time.  
• If you don’t qualify for a lower interest rate, applying with a cosigner who has strong credit can help you secure a better rate. 

Cons:

• If you default on the loan payments, your cosigner’ will have to make good ib the outstanding amount. In addition, it damages your credit. 

6. Revolving Credit

Revolving credit refers to types of personal loans where you get a line of credit for a set period of time. A credit card is one of the most common types of revolving credit. The lender or credit card issuer sets a monthly credit limit on your card. You can borrow up to your credit limit for the month or a 30-day cycle. You have to pay the outstanding every month on a fixed payment due date. The amount you owe will depend on your expenditures during that month. 

As soon as you clear the balance in full, your credit limit gets restored for the following month. Hence the name ‘revolving credit’. Your credit card issuer will charge you a late fee fine and interest on the outstanding if you don’t pay the bill on time. Credit cards have the highest interest rate of all types of loans. Paying a late fee fine and interest could push you further into debt. 

Pros: 

• Credit card approval is fairly easy if you have a steady source of income.  
• Revolving credit can be very useful when you need to pay bills that are due but don’t have easy access to the necessary funds. 
• Credit cards offer a variety of attractive perks such as points, cashback and other rewards. These can help you save a lot of money on future purchases. 

Cons: 

• The high-interest rates are the biggest downside of these types of loans. Credit cards have the highest interest rates. If you don’t pay off the balance on time, you’ll pay a lot in interest and late fees. 

7. Installment Loans

Installment loans are the opposite of revolving credit. With installment loans, you borrow the amount of money you need at one time. You then pay the money back with interest in monthly installments. Student loans, vehicle loans, and home loans are all types of installment loans. 

Installment loans have a start date and an end date. Ideally, you should have paid the full amount back by the end date. If you extend the loan term, you’ll pay more as more interest accrues over the longer term. 

Pros: 

• These types of loans are great if you need funds for a specific purpose. You only borrow what you need and can choose a loan term that makes the monthly payments affordable. 

Cons: 

• Once you sign the loan agreement, you can’t adjust the amount you need to borrow or the interest rate. The loan and the interest rate are fixed and you have to abide by the terms and conditions. The only way to adjust either the loan amount or the interest rate is by refinancing the loan.  

Which Type Of Personal Loan Is Right For You?

The best type of personal loan for you will depend on a number of different factors. 

An unsecured loan may be the best option for you if you have good credit and don’t want to put up any asset as collateral. Your high credit score will qualify you for a lower interest rate. 

A secured loan may be a better option if your credit score is bad but only provided that you have an asset to put up as collateral. 

Choose a fixed-rate loan if finances are tight and you need to know exactly how much to set aside for the payments every month. Fixed-rate is also better than a variable rate for longer-term loans.  

Variable-rate loans work better for the short term as interest rates generally don’t fluctuate a lot over a short period of time. 

A cosigned loan can help you get approved for a low-cost loan if your credit is bad. 

Revolving credit is a good option for you if you’re sure you’ll pay the balance in full every month. You’ll save a lot in interest and also benefit from the other perks. 

If you need a fixed amount for a specific purpose, taking an installment loan can help. 

The key to finding the best type of loan for you is to consider what you need the money for and your overall financial circumstances.  

You can compare your personalized rates with our lending partners and potentially lower your monthly student loan payments and save money.