5 things you need to know about how personal loans work before you apply

Mortgages pay for the house, car loans pay for the vehicles, but personal loans can pay for just about anything.

Key points

• Not all personal loans are created equal.
• The higher your credit score, the lower your interest rate.
• If possible, avoid loans with fees.

Like most financial products, personal loans have both good and bad features. Here we explain how personal loans work and what you need to know before applying. The better prepared you are, the more likely you are to have a positive experience.

1. How a personal loan works

Personal loans are a type of installment credit. Once your loan application is approved, the lender will issue you a one-time payment. Typically, this payment is deposited directly into your bank account. You are then responsible for repaying the loan in installments (usually monthly payments are due).

The length of the loan is called the “term”. This is how long you have to repay the loan in full. The APR is the amount of interest plus other fees you will be charged for borrowing money.

Most personal loans can be used for any purpose. For example, to renovate a house, do car repairs, pay for a wedding or consolidate debt.

2. The higher your credit score, the lower your interest rate

The majority of personal loans do not require any collateral. This means that the lender lends you money based solely on your promise to pay. Since the lender bears all the risk, they will base the final APR you pay on how risky they perceive your loan to be. The higher your credit score, the more confident the lender will be that you will repay the loan. After all, your credit score indicates how you’ve managed your debts in the past.

The lower your credit score, the riskier your loan appears to be and the higher your APR is likely to be. If your credit score is low, you are also likely to be approved for a loan with fees, which those with higher credit scores can usually avoid. While your Personal loan may cost more, if you use it to pay off debt carrying an even higher APR, you could have money up front.

3. Some personal loans are more forgiving than others

If you just graduated from college, some lenders forgive you for having little or no credit history. There are other lenders that allow you to defer payments if you lose your job.

4. Fees are eating away at your personal loan

If possible, it is beneficial to avoid loans charging fees for things like loan origination, administration, and prepayment penalties. Here’s how the fee works: Let’s say you borrow $15,000 and the loan fee is $1,500. Before writing you a check, the lender will deduct $1,500 from the amount you borrow. This means that $13,500 will land in your Bank account rather than $15,000. Yet you are responsible for paying back the full $15,000 plus interest.

All lenders are not created equal. One may quote you an APR of 7% while another quotes 9%. Most personal lenders only run a soft credit check before telling you if your application has been approved and, if so, what your APR will be. That’s good news, because it means you can shop around with as many lenders as you want without hurting your credit score.

The caveat is that a few lenders do a rigorous credit check, so be sure to ask before submitting an application.

The sheer versatility of personal loans makes them an attractive financial tool. Before applying for a loan, be sure to read the fine print to know what you’re getting into.