What is a personal loan?
A personal loan is a type of installment loan where you borrow a fixed amount of money and repay it in regular, fixed payments over a set period. According to the Consumer Financial Protection Bureau (CFPB), a personal installment loan is a closed-end credit product: you receive all the funds upfront and pay them back in equal installments over a defined term.
Personal loans are typically unsecured, meaning they don't require collateral, but some lenders offer secured options. The loan is deposited as a lump sum into your bank account, and you make monthly payments that include both principal (the amount borrowed) and interest (the cost of borrowing).
- Closed-end loan with a fixed amount and repayment term.
- Most personal loans are unsecured, but secured options exist.
- Repaid in fixed monthly installments.
- Range from a few hundred to thousands of dollars.
Sources: Consumer Financial Protection Bureau, Bankrate
How loan payments are calculated: principal, interest, and term
Your monthly payment on a personal loan is determined by three factors: the principal (the amount you borrow), the interest rate, and the loan term (the length of time you have to repay). For a standard personal loan, these payments are fixed, so the amount you pay each month stays the same for the life of the loan.
Lenders use an amortization formula to calculate your fixed monthly payment. In plain text, the formula is: M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1 ], where M is the monthly payment, P is the principal, i is the monthly interest rate (annual rate divided by 12), and n is the number of monthly payments. This example assumes no fees and that the interest rate remains fixed for the entire term.
A longer term results in lower monthly payments but may increase the total interest you pay over time.
Sources: Bankrate, National Council on Aging
Understanding APR and interest rates
The interest rate is the percentage a lender charges on your outstanding loan balance. However, the Annual Percentage Rate (APR) is a broader measure: it includes the interest rate plus certain fees and other costs, giving you a more complete picture of the total cost of borrowing.
When comparing personal loan offers, it's important to look at the APR rather than just the interest rate. The APR helps you compare loans with different fee structures on a more equal basis. Some lenders may advertise lower interest rates but charge higher fees, which can make the APR higher than the nominal rate.
Sources: Experian
Amortization: how early payments are interest-heavy
Personal loans are amortized, which means your monthly payment is split between paying off the interest that has accrued and reducing the principal balance. In the early months of the loan, a larger portion of your payment goes toward interest because your outstanding balance is high. As you pay down the principal, the interest portion decreases, and more of your payment goes toward reducing the loan balance.
This is why paying off a loan early can save you money on interest: by reducing the principal faster, you reduce the amount of time that interest can accrue. If you make extra payments or pay off the loan before the end of the term, you may be subject to a prepayment penalty, depending on your lender.
Sources: Experian, Investopedia
Typical personal loan features: fixed payments, unsecured vs. secured
Personal loans come with a set of features that distinguish them from other types of credit. Most personal loans offer fixed payments and a fixed interest rate, meaning your monthly payment stays the same throughout the loan term. This can make budgeting easier compared to variable-rate credit products like credit cards or personal lines of credit.
Another key feature is whether the loan is secured or unsecured. Unsecured personal loans do not require collateral, such as a home or car, and are the most common type. Secured personal loans are backed by collateral, which the lender can claim if you default. Terms and rates vary by lender and the type of collateral, so review the specifics of any secured loan offer.
Sources: Bankrate, National Council on Aging
Loan uses and restrictions
Personal loans are versatile and can be used for a wide variety of personal purposes. Common uses include debt consolidation, making large purchases, covering unexpected expenses, and financing home repairs. Because these loans are typically unsecured, the funds can be used as you see fit, subject to your lender's terms.
While personal loans offer flexibility, some lenders may have restrictions on how you use the funds. Restrictions can vary by lender, so check your loan agreement for any prohibited uses.
Sources: Bankrate, National Council on Aging
Frequently asked questions
How long do you have to pay off a personal loan?
Personal loan repayment terms commonly range from one to seven years, depending on the lender. Shorter terms generally mean higher monthly payments but lower total interest, while longer terms reduce monthly payments but increase total interest cost.
Sources: Bankrate, National Council on AgingCan I pay off a personal loan early?
Yes, many personal loans allow you to pay off the balance early without penalty. However, some lenders charge a prepayment penalty, which is a fee for paying off the loan before the end of the term. Check your loan agreement or ask your lender about prepayment penalties before making extra payments.
Sources: InvestopediaWhat happens if I miss a payment?
If you miss a payment, your lender may report the missed payment to credit bureaus, which can negatively affect your credit score. Contact your lender as soon as possible to discuss options that may be available, such as a payment plan.
Sources: Consumer Financial Protection BureauDo personal loans affect your credit score?
Yes, personal loans can affect your credit score. When you apply for a loan, the lender may perform a hard inquiry, which can temporarily lower your score. Then, as you make payments on time, you can build a positive payment history, which can improve your credit. Missing payments can hurt your score.
Sources: Consumer Financial Protection BureauWhat is the minimum credit score for a personal loan?
Lenders do not have a universal minimum credit score requirement. Generally, a higher credit score can help you qualify for lower interest rates and better terms. Many lenders consider credit history, income, and existing debts when evaluating an application.
Sources: Consumer Financial Protection BureauSources
- What is a personal installment loan? — Consumer Financial Protection Bureau
- How To Calculate Loan Payments And Costs - Bankrate — Bankrate
- What Can a Personal Loan Be Used For? — Experian
- Personal Loan: What It Is, How It Works, and How to Get One — Investopedia
- What Are Personal Loans? A Guide for Older Adults — National Council on Aging