Personal Loans Explained: How They Work

If you've ever needed money to cover a large expense, consolidate debt, or handle an unexpected bill, you may have considered a personal loan as an option. Personal loans are a type of installment credit that you pay back with interest over a fixed term.

But before taking one out, it's worth understanding how they work, what they cost, and whether one is right for your situation. In this article, we explain what personal loans are, the different types available, and what to consider before you apply.

Key points

• Personal loans are a form of installment credit where a lender provides a lump sum that is repaid with interest over a fixed term through regular monthly payments.
• The cost of a personal loan is affected by the interest rate, loan term, and any associated fees. A higher credit score typically makes it easier to qualify for a loan and may result in a better interest rate or loan terms.
• Personal loans can be used for a range of purposes including debt consolidation, medical costs, home improvements, and emergency expenses.

How do personal loans work?

When a borrower takes out a personal loan, the lender provides a set amount of money, known as the principal, which the borrower agrees to repay with interest over a defined term. Each monthly payment covers a portion of the principal plus interest, so the loan balance decreases over time until it is fully paid off.

Personal installment loan amounts can vary in size from a few hundred dollars to thousands of dollars, and repayment terms can range from months to several years. The monthly payments you make will typically remain the same throughout the entire loan term. ^[1]

Key terms to understand

Interest rate - The interest rate on a loan is the cost you pay the lender for borrowing the money, on top of the principal. A higher interest rate means you’ll pay more in total over the course of the loan.

APR (Annual Percentage Rate) - The APR is the interest rate on the loan plus any additional fees like origination fees charged by the lender, expressed as a percentage. ^[2]

Loan term - The loan term is the length of time the borrower has to repay the loan. Longer terms generally result in lower monthly payments, but more interest paid over the life of the loan. Shorter terms typically mean higher monthly payments but a lower total cost of borrowing. ^[3]

Origination fee - Some lenders charge an upfront fee to process the loan. This is typically expressed as a percentage of the loan amount and may be deducted from the loan proceeds before they are disbursed to the borrower. When an origination fee is present, it is factored into the APR. ^[4]

Prepayment penalty - A prepayment penalty is a fee charged if the borrower pays off the loan ahead of schedule. Under Regulation Z, lenders are required to clearly disclose whether or not a prepayment penalty will be imposed. Not all personal loans include prepayment penalties, and borrowers should review loan terms carefully before signing. ^[5]

Reasons you might use a personal loan

Unlike other types of loans such as auto loans and mortgages, personal loans are not tied to any specific item, meaning you can use them to pay for a variety of different things. When you apply for a personal loan, many lenders will ask that you specify what you intend to use the loan for. Here are a few examples of expenses someone might use a personal loan to pay for:

• Debt consolidation - This enables you to combine multiple high-interest debts into one monthly payment with a fixed interest rate. You could use a personal loan to pay off high-interest credit cards, and then you only have to pay off the personal loan, which will often have a lower interest rate.
• Home improvements - This might include unexpected repairs like a new roof or heating system, or larger home renovation projects.
• Medical costs - Unexpected medical costs can cause financial difficulty for some people. A personal loan can be an option for covering hospital and treatment bills, enabling you to spread the cost over time.
• Emergency costs - Emergencies can happen at any time, from a broken down car to a pet accident, these costs can cause problems if you’re already on a budget. A personal loan can help you cover these costs quickly and give you a structured way to make repayments over time.
• Moving costs - Moving house can be an expensive process with plenty of costs you may not have considered before. Using a personal loan could help cover things like removals services, storage, security deposits and moving supplies. ^[6]

Are there restrictions on what personal loans can be used for?

While personal loans are quite flexible in terms of what they can be used for, lenders can impose certain restrictions. Often, personal loans will not be offered if you intend to use the funds for down payments, business expenses, investing, or certain types of educational expenses. Before taking out a personal loan, be sure to check whether your lender has any such restrictions on what you can use the loan for. ^[6]

When to avoid using personal loans

Personal loans can be helpful if you need to cover certain expenses but you want to spread the cost over a longer period. But there are some circumstances where a personal loan may not be a good idea:

• You are already in debt - If you have a high debt-to-income ratio already, adding more debt in the form of a personal loan could increase financial strain and make it harder to pay back what you owe.
• You don’t have a repayment plan - If you’re borrowing money without a clear plan for how you’re going to repay it, you might end up struggling to pay it back, leading to late payments, additional fees, and credit score damage.
• Paying for unnecessary expenses - Taking out a personal loan to pay for vacations or luxury items that you otherwise couldn’t afford can put you in unnecessary debt and lead to financial strain.
• Long-term investments - Personal loans can often have higher interest rates than other types of financing, so taking one out over a long term can lead to you paying more.
• If there are other options that may be more suitable - You can’t use personal loans for some types of expenses, like car loans or educational financing. In these cases, it’s better to look for more specific types of financing. ^[6]

Types of personal loans

There are a few different types of personal loans you may want to consider, they can vary by security, loan structure, or interest rate.

Security type - unsecured vs secured loans:

• Unsecured personal loans - An unsecured loan doesn’t require collateral to be approved. Usually qualification will be based on your credit score, income and debt-to-income ratio, and you’ll often need good or excellent credit to qualify for the best rates.
• Secured personal loans - Similarly to car loans or mortgages, a secured personal loan requires collateral to be approved. This could be something like a saving account or a certificate of deposit (CD).

Loan structure:

• Debt consolidation loan - These combine multiple loans into one payment, allowing you to save on interest and pay off outstanding balances more quickly.
• Joint loans - Some lenders give the option for you to take out a joint loan with someone else, where you both will have access to the funds and be responsible for payments.
• Cosigned loans - Getting a loan with a creditworthy cosigner can help you qualify for a personal loan if you are having trouble being approved yourself. The cosigner will take equal responsibility for the loan but will not be able to access the funds.

Interest rate:

• Fixed-rate loans - The majority of personal loans come with a fixed interest rate. This means the rate you pay won’t change over the course of the loan, and you’ll pay the same amount each month.
• Variable-rate loans - Some personal loans have variable interest rates which change with the market. This means your interest rate may go down during the life of the loan, but it could also increase, making budgeting for repayments less predictable. ^[7]

What is a good interest rate for a personal loan?

As we mentioned, the interest rate on a personal loan can be either fixed or variable, and the rate you get can depend on things like your credit score, your debt-to-income ratio, and the wider economy.

According to data from Bankrate as of March 2026, the average personal loan interest rate for consumers with a 700 credit score is 12.26% for a $5,000 loan with a 36-month term. The higher your credit score, typically the lower the interest rate on your loan will be, so if you have excellent credit you may be able to qualify for a lower rate. ^[8]

How to apply for a personal loan

If you’re thinking about applying for a personal loan, the steps below outline the process.

1. Check your credit score and credit report - Before applying, review your credit report for errors and get a sense of what rates and terms you may qualify for. A higher credit score generally improves the chances of approval and access to better rates.
2. Determine how much you need to borrow - Calculate how much you need to borrow before applying, as borrowing more than necessary increases total repayment costs.
3. Shop around and compare lenders - Different lenders, banks, credit unions, and online lenders, offer different rates, terms, and fees. Comparing multiple offers helps you find the most suitable option.
4. Check for prequalification - Many lenders allow you to check your estimated rate with a soft credit inquiry, which does not affect your credit score. This allows comparison shopping before formally applying.
5. Gather required documentation - Lenders typically require proof of identity, proof of income, employment information, and details of existing debts.
6. Submit a formal application - A formal application triggers a hard credit inquiry, which may temporarily affect your credit score.
7. Review the loan agreement - Before accepting any offer, review the APR, loan term, monthly payment, fees, and any prepayment penalties.
8. Receive funds - If approved and the agreement is signed, the lender disburses the funds, typically as a lump sum.

^[9]

Bottom line

Personal loans are a form of installment credit that allow borrowers to access a lump sum of money, repaid over a fixed term through regular monthly payments. They can be used for a number of personal reasons, including making a large purchase, covering unexpected expenses, or consolidating existing debt.

The cost of a personal loan depends on several factors, including the interest rate, loan term, and any associated fees. A higher credit score typically makes it easier to qualify for a loan and may result in a better interest rate or loan terms. Before taking out a personal loan, it’s a good idea to compare offers from multiple lenders and review all required loan disclosures to understand any fees before agreeing to a loan.

Source

1. CFPB, “What is a Personal Installment Loan?” https://www.consumerfinance.gov/ask-cfpb/what-is-a-personal-installment-loan-en-2114/ Accessed April 9, 2026
2. CPPB, “What is the Difference Between a Loan Interest Rate and the APR?” https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-loan-interest-rate-and-the-apr-en-733/ Accessed April 9, 2026
3. In Charge Debt Solutions, “Personal Loan Terms” https://www.incharge.org/financial-literacy/personal-loan-terms/ Accessed April 9, 2026
4. Bankrate, “Personal Loan Origination Fees” https://www.bankrate.com/loans/personal-loans/personal-loan-origination-fees/ Accessed April 9, 2026
5. One Main Financial, “What is a Prepayment Penalty?” https://www.onemainfinancial.com/resources/loan-basics/what-is-a-prepayment-penalty Accessed April 9, 2026
6. PNC, “What Can Personal Loans Be Used For?” https://www.pnc.com/insights/personal-finance/borrow/what-can-personal-loans-be-used-for.html Accessed April 9, 2026
7. Bankrate, “8 Types of Personal Loans” https://www.bankrate.com/loans/personal-loans/types-of-personal-loans/ Accessed April 9, 2026
8. Bankrate, “Average Personal Loan Rates” https://www.bankrate.com/loans/personal-loans/average-personal-loan-rates/ Accessed April 9, 2026
9. Experian, “How to Get a Personal Loan” https://www.experian.com/blogs/ask-experian/personal-loans-what-to-know-before-you-apply/ Accessed April 9, 2026

About the author

Becca has over 10 years of experience as a content writer, working across various industries including finance, digital marketing, education, travel, and technology. Her work has been featured in publications including Forbes, Business Insider, AOL, Yahoo, GOBankingRates, and more.

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