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How Personal Loans Work
2 Aug 2018

How Personal Loans Work: A Complete Guide

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The amount of Americans turning to personal loans to help them get past the financial hurdles they’re facing has sharply increased.

To that end, according to information available on TransUnion, in 2010 10.5 million Americans took out personal loans. In 2015, 13.7 million. And in 2016… an estimated 24 million.

Given the popularly of personal loans, those looking for borrowing options may be asking themselves, “How do personal loans work?”

Below, our team has compiled a comprehensive overview of personal loans, what they are, who they are for, and what to watch out for when taking one out.

What Exactly is a Personal Loan?

A personal loan is a loan product that is offered by lenders to consumers looking to borrow money. These loans are unsecured meaning that collateral is not required by the borrower in order to complete the transaction.

Personal loans are a common product offered by many different lending institutions. Some of these institutions include credit unions, brick-and-mortar banks, cash advance services, and online lenders.

How Do Personal Loans Work?

Now that you know what a personal loan is, we’ll answer the question, “How do personal loans work?” Fortunately, personal loans are straightforward.

Upon your applying for a personal loan and your subsequent approval, lenders will award you the agreed upon loan amount. You will be able to use your borrowed funds at your discretion (unless otherwise stipulated by your lending institution).

Prior to applying for a personal loan, you’ll want to be aware of what the terms are surrounding your loan to ensure you can fulfill your end of the loan’s obligations.

Your obligations to a personal loan will be how much you’ll need to pay for it and the schedule in which you’ll need to make your payments.

So, in summary, once you’ve taken out a personal loan you’ll use your loan sum for whatever your needs are. You will then pay back your lender in small installments plus any premiums (interest and other fees).

When is Taking Out a Personal Loan Appropriate?

Personal loans are non-specific in nature meaning that you can use funds borrowed at your discretion. This is in contrast to specified loan types such as home loans or auto loans.

Given how general personal loans are, reasons for receiving and purposes for utilizing them vary widely from borrower to borrower.

Some example of reasons people leverage personal loans include the following:

  • Debt consolidation
  • Home improvements
  • Medical Expenses
  • Weddings
  • Pet Expenses
  • Tax Obligations
  • Vacations
  • Vehicle Repairs

The above is by no means a comprehensive list but should give you a base idea of how personal loans get leveraged.

Are All Personal Loans the Same?


Personal loans will vary widely from lender to lender. For that reason, it’s imperative that you shop around when seeking out a personal loan.

Factors that will vary from lender to lender include interest rates and fees.

What is an Interest Rate?

An interest rate stipulates how much you will need to pay back to your lender in addition to your loan’s principal sum (the amount of money you borrowed).

As an example, let’s assume that you borrowed $100.00 from a loan provider at a 10% interest rate. In theory, you would be obligated to pay back your original $100.00 plus 10% of that amount. That’s $110.00 in total.

Where this gets complicated is when you become delinquent on your loan payments.

If you borrowed $100.00, owed $110.00 and did not pay back that sum when you were required to do so, depending on your lender, your loan may incur an additional 10% charge. This charge is not on the original $100.00 you borrowed but on your newer $110.00 balance.

That means you would now owe $121.00.

The concept outlined above is called compound interest. Compound interest can snowball the amount you owe substantially and make it so your loan balance is insurmountable.

For that reason, there are few things more important in regard to how do personal loans work than keeping tabs on your payment obligations.

What Kind of Fees Get Charged on Personal Loans?

Fee types on personal loans and whether or not fees are charged at all will vary depending on the lender. Common fees you may encounter are as follows:

Loan Origination Fee

This fee gets charged to borrowers for taking on a loan product. The only way to avoid this fee is by picking a lender who doesn’t impose it.

Application Fee

This is a fee charged by some lenders for considering your application. This fee is only avoidable by doing business with a lender who doesn’t impose it.

Late Payment Fee

When you take out a loan, the schedule in which you’re excepted to make payments on that loan amount will get laid out. If you miss your payment windows, this fee will be applied to your loan balance. If adverse conditions led to your missing a payment, calling your loan provider and explaining the situation may lead to the fee getting waved.

Check Processing Fee

If you pay your loan balance by check, lenders may charge a small fee to compensate them for the extra effort required to manage checks. You can avoid this fee by paying back your loan in whatever your lender’s preferred payment method is.

Prepayment Fee

This is a fee that gets charged by a decreasing amount of lenders. The faster you pay off your loan, the less monthly interest your loan provider will be able to make off of you. For that reason, a small portion of lenders charge a fee to offset their losses if you pay back your loan too fast.

What Role Does Credit Play in Personal Loans?

As with most money borrowing products, your credit score will have implications on the type of product you’re eligible for. Depending on your credit, certain lenders will or won’t be willing to lend to you and those that are willing will offer you different terms on your loan.

For example, people with poor credit may get charged higher interest rates on their personal loan. They may also have less leverage in waiving fees. In contrast, if you’re shopping for a personal loan with excellent credit you can be sure that your lender will offer you their best personal loan terms and conditions.

Answers to the question of how do personal loans work vary widely depending on your credit given how loan terms will change accordingly. As a best practice, consider building your credit as much as possible prior to seeking out loans to make sure you don’t overpay.

When Should You Avoid Personal Loans?

Just because you can take out a personal loan does not mean you should. If you’re taking out personal loans to help build your credit, to pay for large purchases or to splurge, there are better ways to achieve those ends.

For credit building, consider making timely payments on other debt you already have in your portfolio. For one-off purchases or splurges, you’re better off creating a savings plan than funding purchases with borrowed, interest accruing money.

What Happens If You Don’t Pay Back Your Loan?

Penalties for loan delinquency will vary depending on your lender. You can usually expect that your credit score will suffer and that you will need to pay additional fees on your loan if you don’t make timely payments.

If you are radically delinquent on your debt, your loan may get sent to a 3rd party agency who may harass you until you pay off your owed amount.

Wrapping Up How do Personal Loans Work

The above information should give you an overview of how do personal loans work. For more extensive how loans work information, consider contacting the lender you’re thinking of working with.

Generally, personal loans are a great tool for borrowers looking for ways to get money at interest rates better than what they’d find with credit cards.

Personal loans are great for consolidating debt and for paying down necessary expenses. They also offer consumers funding without the need for collateral which puts most of the risk on lenders.

Still, it’s important that you take the risk factors we have discussed in this how do personal loans work article seriously. Going delinquent on personal loan payments can have a deep negative impact on how much you pay for your loan and your ability to borrow money in the future.

If you’d like to take your curiosity on how do personal loans work a step further and actually find a loan product that’s right for you, our team can help!

Bonsai Finance helps you quickly find a variety of lenders online who will consider your personal loan application. Upon approval, you could get your money as quickly as the day of your application.

Click here to get started on your qualified personal loan search or for more financial information, read more in the Bonsai Finance learning center!