How Do Personal Loans Work? [And the Best and Worst Ways To Use Them]

According to recent data from Experian, 22% of American adults have a personal loan and carry an average balance of $16,458. Consumers use these loans to cover unexpected expenses, consolidate debt, finance home renovations, and more.

Personal loans can be an attractive option due to their flexibility and relatively low interest rates. Still, they might not be the best solution for everyone, so it’s essential to understand how personal loans work before you sign your name on the dotted line.

How do personal loans work?

Personal loans can be used for just about any purpose unless the loan explicitly states how you must use the funds. They are a type of installment loan, which means you borrow a set amount of money and repay the loan over a fixed number of payments, or “installments.” They’re also typically an unsecured loan, which means they aren’t backed by collateral, such as your home or car.

You can apply for personal loans at banks, credit unions, and online lenders. The amount of money you can borrow varies from lender to lender, but as you shop around, you’ll likely find loan offers somewhere between $1,500 and $100,000.

With an unsecured personal loan, the loan amount and annual percentage rate you qualify for is often based on your credit profile, which includes your income, credit history, and credit score, among other factors. Typically, the better your credit score, the more favorable the interest rate you’re likely to receive.

Personal loans generally have fixed interest rates, which means the interest rate remains the same over the life of the loan. If it’s predictability you’re after, a fixed-rate loan might be the way to go. By contrast, variable-rate loans could have lower interest rates, but the rates will fluctuate with the market. Variable-rate personal loans are less common than fixed-rate options.

8 best ways to use a personal loan

Consumers use personal loans for lots of reasons, but like any financial product, it’s a good idea to use them only when it makes sense. Also, make sure you can afford the monthly payment each month before you move forward.

If you’re wondering whether a personal loan makes sense for your situation, here are some of the most common reasons to get a personal loan:

1. Debt consolidation

If you have good to excellent credit, personal loans could allow you to save money by paying off higher interest rate debt with a low-interest loan. For instance, you might use your loan proceeds to pay off higher-interest credit card debt and then repay your lower-interest personal loan over time. With lower interest costs, you might be able to get out of debt faster.

2. Home remodeling

Personal loans could give homeowners a way to upgrade their homes by covering the cost of home improvement projects. Many consumers prefer personal loans over home equity loans or home equity lines of credit because they typically don’t require you to use your home as collateral.

3. Emergency expenses

A personal loan could potentially provide welcome relief when life throws you a financial curveball. For example, if you’re suddenly faced with unexpected medical bills or funeral costs, a personal loan could help if you don’t have enough available funds in your emergency fund. Again, just make sure you can afford the monthly loan payment so you aren’t struggling financially.

4. Household purchases

Sometimes, the unexpected happens, such as when your refrigerator or washer and dryer suddenly quit working. Personal loans could offer a way to make a large purchase relatively quickly without waiting several months to save up enough money.

5. Moving costs

According to Moving.com, it costs an average of $1,250 to move locally and $4,890 to move a distance of at least 1,000 miles. If you’re short on funds, or you’re changing jobs and moving to a new town, you may be unable to pay moving expenses. In this case, a personal loan could help you pay for your move without depleting your savings.

6. Wedding expenses

From the engagement ring and bride’s dress to the reception and photography, weddings can cost a pretty penny. Although paying for these costs upfront is generally a good idea, sometimes it’s not possible. A personal loan could be a useful alternative to help cover the cost of your dream wedding.

7. Credit building

Credit builder loans, which are a type of secured personal loan, might be a good option if you have a limited credit history. Making regular payments on time could be an excellent way to build or rebuild credit. And, if you already have other types of credit, adding a secured loan can diversify your credit mix, which accounts for up 10% of your credit score.

8. Veterinary bills

Veterinary services for your pet are often quite expensive, especially if advanced treatments and surgeries are involved. These costs can also crop up unexpectedly. When your furry family member needs necessary care, a personal loan could help you cover costs and repay them over a longer period of time without depleting your savings.

4 worst ways to use a personal loan

There are times when getting a personal loan may not be the best choice. Some of the worst reasons to get a personal loan are as follows:

1. Vehicle purchase

Auto dealers and credit unions often offer financing with lower interest rates than you’ll find with personal loans. That’s because a borrower’s vehicle serves as collateral on an auto loan, which can help mitigate some risk to the lender.

2. Further debt

It could be wise to consolidate your high-interest debt into one low-interest personal loan. But it’s essential to avoid running up new charges on your cards. If you’re living beyond your means, taking on further debt, including personal loans, is generally not the best idea.

3. Dream vacation

Vacations can be good for your soul and a necessary component of a healthy work-life balance. However, getting a personal loan and going into debt for several months or even years to fund a dream trip isn’t a great strategy. A better alternative could be creating room in your budget for vacation savings so you don’t have to go into debt and pay interest long after your vacation is over.

4. Higher education

You could pay for tuition and college expenses with a personal loan. But federal subsidized loans deliver valuable benefits and protections, which you’d give up if you opted for a personal loan instead. These benefits could include low interest rates and the ability to avoid paying interest while you’re in school. Federal student loans might also allow you to postpone payments if necessary, and you may even be eligible for loan forgiveness.

What to consider as you shop for personal loans

Want to know how to get a loan with the best term and rates? Some key considerations include credit score, loan rates, and repayment terms, which directly affect your payment amount.

Your credit score

Generally, the higher your credit score, the more likely you are to see a better interest rate on a personal loan. If you have a FICO credit score in the good range (670-739) or better, you might have more loan options, too. If your credit score is below that range, consider pausing your efforts to get a personal loan and taking some time to build your credit. With improved credit, you’re more likely to get better rates and terms.

Loan rates and repayment terms

Interest rates for personal loans vary widely and depend on the lender, loan term, your credit score, and other factors. Generally, the goal is to get the lowest interest rate possible to keep your monthly payment as low as possible.

According to the most recent data from the Federal Reserve, the average APR for 24-month personal loans is 9.58%, which is well below the 16.30% average APR for credit cards. With such a disparity in interest charges, it’s easy to see why consumers choose to consolidate credit card debt with personal loans.

Like interest rates, your loan term also has a direct impact on your monthly payments. The longer you pay interest, the higher your loan is likely to cost.

Lender reputation

When you apply for a loan, the lender typically requires you to share a fair amount of personal information, including your contact information, Social Security number, credit history, and more. That’s why it’s so important to make sure the company you’re dealing with is legitimate.

You can review the company website and look for contact information, including a phone number, address, and email. Also, look for the Federal Deposit Insurance Corp. logo or an indication that the lender is FDIC-insured. While the FDIC insures deposits and not loans, having this type of insurance could speak to the bank’s legitimacy.

You may also want to do further research if a lender is unfamiliar to you. Look at customer reviews on the Better Business Bureau and any recent news stories mentioning that bank or credit union.

Alternatives to personal loans

Personal loans could potentially cost more than other alternatives, though not always. Here are some personal loan alternatives to consider:

Balance transfer credit card

With good or excellent credit, you may be able to qualify for a credit card with a 0% APR on balance transfers. These types of 0% APR credit cards offer an introductory period with no interest, so they might be a good option for transferring higher interest credit card debt.

For example, the Citi Double Cash^® Card offers a 0% introductory APR on balance transfers for 18 months (then 19.24% - 29.24% (Variable)). It can give you a grace period to pay off your debt without incurring interest charges, though you’ll want to be sure to pay off the balance before that grace period ends.

For more details, check out our full Citi Double Cash Card review.

Home equity loan

A home equity loan could allow you to borrow from the equity you’ve built in your home. Many consumers prefer home equity loans vs. personal loans because they might come with a lower interest rate. A home equity loan can be a good idea for homeowners who plan to use the funds to renovate their homes and increase the property’s value.

The main drawback to home equity loans is that your home serves as collateral, which means you could lose your house if you default on the loan.

Home equity line of credit

As with home equity loans, HELOCs could allow you to access the equity in your home. You can use the funds for any purpose, but they are commonly used for home improvement projects.

However, unlike home equity loans which are generally lump-sum payments, HELOCs work like credit cards, providing a revolving line of credit you can draw from.

Similar to a home equity loan, your home serves as collateral with a HELOC. Because of this, these loans might have lower interest rates, which makes them an attractive alternative to personal loans for many borrowers. Before you sign for a HELOC, remember to account for the upfront fees and costs.

A HELOC could be a good option if you have considerable equity in your home and want a potentially inexpensive way to borrow money.

FAQs

The bottom line

Personal loans are installment loans you can use in numerous ways for your benefit, such as consolidating high-interest loans, funding a home renovation project, or paying for an unexpected expense. But, as with any financial product, it’s a good idea to do your due diligence and run the numbers to make sure it makes sense. Have a clear understanding of how the payments will impact your budget and follow a plan to pay off the loan.

If you’re in the market for a loan, FinanceBuzz makes it easy to compare quotes from top lenders. Check out our picks for the best personal loans.