What is a personal loan and how does it work?

By Corey Buhay | Published on March 30, 2026

)

Whether you want to consolidate high-interest debt, cover an unexpected car repair, or fund a home renovation, a personal loan might come in handy. Typically offered by banks, credit unions, and online lenders, it provides a lump sum of money upfront.

Once you collect the funds, you repay what you borrow plus interest through fixed monthly installments over an agreed-upon term. Let’s dive deeper into some personal loan basics and how personal loans work so you can determine whether you could benefit from them.

Types of personal loans

In most cases, personal loans are unsecured loans, meaning they don’t require collateral or an asset you own like your house, car, or savings account. When you apply for an unsecured or uncollateralized loan, the lender will likely look at your credit score to determine whether to approve you. Your credit will also influence the rate you receive.

Secured loans are backed by collateral. If you can’t make your payments on an unsecured loan, the lender has the right to repossess your asset and recoup their losses. For this reason, secured loans are usually available to borrowers with lower credit scores and come with better rates.

How lenders determine terms for personal loans

Once you apply for a personal loan, lenders will likely consider the following to decide your terms.

• Credit score: Your credit score shows lenders how likely you are to repay your loan. A higher score positions you as a responsible borrower and in turn, may lead to lower rates.

• Debt-to-income ratio: Lenders care about your debt-to-income (DTI) ratio because it explains how much of your monthly income goes toward debts. The lower your ratio, the better terms you may receive.

• Income and employment history: Whether you work a traditional job, own a business, or don’t work at all can affect your rates. Lenders prefer borrowers who can prove they have a stable income source.

• Loan amount: It’s usually easier to qualify for good terms with a smaller personal loan than a larger one because it’s less risky for lenders. If you want to borrow $40,000 instead of $4,000, for example, you might have to settle for a higher rate.

What’s the difference between interest rates and APR for personal loans?

An interest rate refers to how much you’ll pay a lender to borrow money and a lower rate usually results in lower monthly payments. Annual percentage rate (APR), on the other hand, is the total cost to borrow money and includes your interest rate plus any fees. A lower APR leads to a lower overall cost of borrowing.

Also, interest rates can either be fixed or variable. While a fixed rate is set in stone and doesn’t change over time, a variable rate may vary, depending on market conditions. A fixed rate lets you budget for your monthly payments in advance while a variable rate means they’ll likely fluctuate over time.

What is the repayment structure for personal loans?

Although every personal lender has their own terms, anywhere from 1 to 5 or 7 years is typical. Once you receive your funds, you’ll repay them with interest through fixed monthly payments over your predetermined term.

As you pay down your loan balance, you’ll find that the interest portion of your payment will decrease while the payment toward your balance will increase, allowing you to pay off your loan faster.

Pros and cons of personal loans

Just like all financial products, personal loans have several benefits and drawbacks. Let’s dive deeper into what they are.

Pros

• Flexible: You may use the loan funds for almost any purpose, such as medical bills, debt consolidation, and home improvements.
• Various loan amounts: Most lenders offer personal loans that range from $1,000 to $100,000, making it easy to cover a variety of small and large expenses.
• Fast funding: You can receive the funds, usually through direct deposit the same day you get approved, the next day, or within a few business days.

Cons

• Increased debt burden: When you take out a personal loan, you automatically increase your debt-to-income ratio, which can hurt your credit.
• Potential fees: Many lenders charge fees in addition to interest, such as origination fees, application fees, and late fees.
• Negative credit impact: Once the lender performs a hard inquiry to check your credit after you formally apply, your score may temporarily go down by a few points.

What can you use personal loans for?

Most lenders let you use the loan funds for virtually any purpose. You might put them toward unexpected expenses like car repairs and medical bills. Or, they may help you cover a planned expense like a home improvement project or wedding. A personal loan can also allow you to consolidate high-interest debt and potentially save money on interest.

Could a debt consolidation loan actually save you money?

Let’s say you’re carrying $20,000 in high-interest credit card debt with an average APR of around 19.6%. If you make a typical monthly payment of about $440, you could end up paying nearly $17,000 in interest over seven years. That’s almost as much as the original balance—money that goes toward interest, not progress.

Now imagine consolidating that same $20,000 into a personal loan with a lower, fixed rate—say 12% APR. Your monthly payment could drop to around $353, and over the same seven-year period, total interest paid could fall to about $9,657. That’s an estimated savings of more than $7,000 in interest alone.

Actual savings will vary based on your rate and terms, but this is why debt consolidation can be more than just a simplification strategy—it can be a real way to keep more of your money working for you.

)

Are there any risks with personal loans?

Before you sign on the dotted line and commit to a personal loan, carefully consider the potential risks. Do your best to only borrow what you need and can comfortably afford to pay back. If you overborrow, you might find yourself in a cycle of debt.

In addition, make all your payments on time to avoid late fees as well damage to your credit score. If you plan to pay your loan off early, find a lender that won’t charge prepayment penalties.

FAQs

Can I get a personal loan with bad credit?

Yes, you may get approved for a personal loan, even if you have bad credit but you might have to settle for a higher interest rate. Applying with a cosigner or taking out a secured loan can help lower your rate.

How long does it take to get personal loan funds?

Each lender has their own funding time. Some lenders offer same-day or next-day funding while others might take a few days or even weeks to disperse your funds.

How do personal loans compare to credit cards?

A personal loan may be a better option for larger expenses and debt consolidation, especially if you can lock in a low interest rate. A credit card, on the other hand, might make more sense for small, daily purchases, as long as you’re confident you can pay your balance in full every month and avoid interest.

About the Author

Corey Buhay

Corey Buhay is a writer and editor based in Boulder, Colorado. She’s passionate about literature, the outdoors, and doing her taxes by hand. She has been writing about student loans and personal finance for Earnest since 2019.