Personal Loan Definition: Types, How Does It Work and Its Uses

A personal loan is a type of borrowing that offers individuals access to a fixed amount of unsecured money used for various purposes. The personal loan definition encompasses a borrowing arrangement where individuals can access funds for multiple purposes without providing collateral. The loans are characterised by fixed or variable interest rates and defined repayment terms. Types of personal loans encompass a range of options tailored to different needs, including unsecured personal loans, secured personal loans, credit-builder loans, and specialised loans offered by service-oriented companies. Unsecured personal loans do not require collateral, while secured loans necessitate assets as security. Credit-builder loans help individuals establish or rebuild credit histories, while specialised loans cater to specific needs, such as financing for home improvements or medical expenses.

The functioning of a personal loan involves the borrower applying for a specific loan amount, undergoing a credit check, and receiving the funds as a lump sum upon approval. Repayment occurs through fixed monthly instalments over a predetermined period, with interest accruing based on the loan's terms. Borrowers use personal loans for various purposes, including debt consolidation, home renovations, medical bills, education expenses, or unexpected financial needs.

Understanding the types available, how they operate, and their potential uses empowers borrowers to make informed decisions regarding their financial needs and goals. Consider credit score, income, debt-to-income ratio, and loan terms when applying for a personal loan. Individuals accomplish their financial goals with little risk by considering these factors when choosing a loan, ensuring it is affordable, and managing repayment well.


What is a Personal Loan?

A personal loan is a financial product offered by banks, credit unions, and online lenders, enabling people to borrow a specific sum of cash for various purposes. One defining characteristic of personal loans is that they possess fixed interest rates, meaning the interest rate remains constant throughout the life of the loan. It makes borrowers' monthly payments predictable, making budgeting and planning repayment easier.

Personal loans often feature relatively quick funding, with many lenders offering same-day or next-day approval and disbursement of funds upon approval. The rapid access to funds is particularly advantageous for individuals facing unexpected expenses or borrowers seeking to seize time-sensitive opportunities.

One of the key benefits of personal loans is their flexibility in use. Borrowers utilise personal loans for various purposes, including consolidating high-interest debt, financing home improvements, covering medical expenses, funding weddings or vacations, or even starting a small business. The versatility makes personal loans valuable for individuals seeking various financial goals.

Loans offer convenience and flexibility, but they are relatively expensive forms of borrowing, especially compared to secured loans such as mortgages or auto loans. It is because personal loans are unsecured, meaning they don't require collateral to be obtained. Personal loans come with higher interest rates than secured loans to compensate for the greater danger to lenders. Borrowers must weigh their options and consider personal loan terms and costs to get the best deal. Choosing the right loan type is crucial to receiving the most beneficial option.

Personal loan

How do Personal Loans Work?

A personal loan permits people to obtain a specified sum from a bank or financial institution without requiring collateral and agreeing to repay it over a predetermined period through consistent monthly payments. The loans are unsecured, meaning borrowers aren't obliged to provide assets as security for the borrowed amount. Loan amounts vary widely, ranging from £1,000 to £50,000 or more, with interest rates currently spanning from approximately 6% to 36%. Repayment terms extend from one to seven years, offering flexibility to borrowers in tailoring their repayment schedules to their financial capabilities.

Individuals must complete an application process to obtain a personal loan, which involves providing personal and financial information to the lender. The process takes from a few hours to several days for approval. The lender pays the borrower straight from their bank account after they have been approved for the loan. Borrowers begin paying back the loan according to the agreed-upon terms, with principal and interest due each month.

Lenders commonly report borrowers' payment activities to credit bureaus throughout the loan term. Timely repayment is essential, as it contributes to building a positive credit history and facilitating future borrowing endeavours. Various terms are encountered when seeking a personal loan, including the interest rate, which determines the additional cost borrowers incur over the loan's lifespan. Borrowers are presented with a fixed monthly payment amount, calculated by combining the principal and interest, which are adjusted based on the chosen repayment period. Repayment terms range from one to seven years, although some lenders extend them to up to 12 years for larger loans. Some borrowers encounter origination fees, initial charges added to the loan amount, reaching as high as 10%, contributing to the entirety of the cost.


What are Personal Loans Used For?

Personal loans are used as listed below.

  • Debt consolidation: Combining multiple debts, especially credit card debt, into a single loan with a lower interest rate and more manageable monthly payments.
  • Medical bills: Covering unexpected medical expenses or healthcare costs that arise. 
  • Home repairs and renovations: Financing repairs, improvements, or renovations to one's home.
  • Repaying family or friends: Settling debts owed to relatives or acquaintances.
  • Wedding expenses: Funding various aspects of a wedding, including venue, catering, attire, and more.
  • Divorce costs: Covering legal fees, settlements, or other expenses associated with divorce proceedings.
  • Moving expenses: Funding costs related to relocating, such as hiring movers, transportation, or temporary housing.
  • Funeral costs: Paying for funeral arrangements, burial or cremation services, or related expenses.
  • Vacations: Financing travel expenses, accommodation, activities, and other vacation-related costs.
  • Furniture or appliance purchases: Buying new furniture, appliances, electronics, or other household items.
  • Small business expenses: Supporting business endeavours, such as startup costs, inventory purchases, or operational expenses.
  • Holiday shopping: Funding purchases for gifts, decorations, travel, or other holiday-related expenses.

What are Personal Loan Examples?

Some personal loan examples include consolidation of debts, home enhancements, and wedding costs. A personal loan is one adaptable way to get the money needed to accomplish one's objectives. Personal loans enable people to consolidate debt, make home improvements, or finance a significant life event such as a wedding. They provide quick access to funds and allow them to repay them over time so they achieve their goals while managing their finances well.

One typical example of using a personal loan is for debt consolidation. Suppose an individual has accumulated various high-interest debts, such as credit card balances, medical bills, and personal loans. They take out a personal loan to consolidate these debts into a single loan with a lower interest rate. They have the option to simplify their debt repayment process, reduce their overall interest costs, and have a clear timeline for becoming debt-free.

Another example is using a personal loan for home improvement projects. Say a homeowner wants to renovate their kitchen or add an extension. They take out a personal loan to cover the costs of materials, labour, and other expenses associated with the project. They are able to get the money they need right away and pay it back over time with a personal loan instead of having to wait to save enough for home renovations.

Personal loans are commonly used to finance wedding expenses. Planning a wedding is costly, with venue rental, catering, photography, and attire quickly adding up. People who want to get married but do not have enough money are able to get a personal loan to help pay for their dream wedding. It allows them to create the wedding they envision without negatively affecting their budget or delaying their plans.


What are the Advantages of Personal Loans?

The advantages of personal loans are listed below.

  • Flexible Use: People who get personal loans do not have to tell lenders ahead of time how they plan to use the money. The flexibility allows borrowers to apply for funding for various purposes, including debt consolidation, weddings, vacations, college tuition, home remodelling projects, and more.
  • One Large Sum: Personal loans, unlike credit cards and lines of credit, give borrowers a large amount of money all at once that they have to use however they need to. Spending money is advantageous for various purposes, such as paying off high-interest credit cards, covering contractor fees for home improvements, or financing a family vacation.
  • Fast Funding: Many personal loan companies offer fast funding, with some providing funds as soon as the same day of application approval. Quick access to cash is crucial for borrowers who need immediate funds for major purchases or to address urgent financial needs.
  • Credit Building: The responsible use of a personal loan helps borrowers build or improve their credit scores. On-time payments and a diverse credit mix are factors in credit scoring models that positively impact credit scores over time.
  • Higher Borrowing Limits: Personal loans allow borrowers to access higher loan amounts than credit cards. Borrowing limits for personal loans range from £2,000 to £50,000 or more, depending on income, credit history, and status as an employee.
  • Lower Interest Rates: Personal loans feature lower interest rates than credit cards, resulting in potential savings for borrowers as they repay their debts. The average interest rate for personal loans is lower than that of credit cards, making personal loans a cost-effective borrowing option.
  • Predictable Repayment Schedule: Personal loans come with a fixed repayment term agreed upon in advance, allowing borrowers to know exactly when they are debt-free. Its predictable repayment schedule contrasts with revolving credit options such as credit cards, which lead to perpetual debt if not managed carefully.
  • Flexible Repayment Terms: Personal loans have set terms for paying them back, and borrowers must pick the best plan. Some lenders offer repayment term options, ranging from 12 to 84 months or even longer for larger loans.
  • No Collateral Required: Most personal loans are unsecured, meaning borrowers do not need to provide collateral to secure the loan. It eliminates the risk of losing assets in the event of default, giving borrowers peace of mind.
  • Easy Application Process: Applying for a personal loan is straightforward, whether through a bank, credit union, or online lender. Fast approvals and money deposited into the borrower's bank account the next business day are hallmarks of online lending.

What are the Disadvantages of Personal Loans?

The disadvantages of personal loans are listed below.

  • High-interest rates: Borrowers with good credit can get low annual percentage rates (APRs), but others have to pay higher rates, which go as high as 36%. The rates significantly increase the cost of borrowing, especially compared to other financing options such as mortgage loans, home equity lines of credit (HELOC), student loans, or 0% APR credit cards.
  • Fees and Penalties: Many lenders charge fees, such as application fees and origination fees, to cover processing costs. Late payment fees and penalties for insufficient funds further increase borrowing costs. Some lenders even charge prepayment penalties, although many competitive lenders do not. Borrowers must carefully review the terms and conditions of the loan to understand all associated fees and penalties.
  • Credit Damage: Late payments or defaulting on a personal loan negatively impact a borrower's credit score. Lenders report positive and negative payment histories to credit bureaus. Missed payments lower a borrower's credit score. Taking out a personal loan increases a borrower's debt burden, affecting credit utilisation and, consequently, their credit score.
  • Required Collateral: Applicants with lower credit scores are required to pledge assets as collateral to secure a loan. The lender has the right to confiscate the collateral in the event of a default on a secured personal loan. Collateral is a house, automobile, boat, or even a certificate of deposit (CD). Pledging collateral risks losing valuable assets in the event of non-payment.
  • Possible Unnecessary Debt: A personal loan causes someone to take on extra debt, depending on their current financial situation and why they want to borrow money. Individuals who wish to borrow money must carefully consider their reasons for doing so and decide if a personal loan is the best option. Avoid borrowing more than is needed and have a clear plan for paying back the loan so it doesn't get stuck in a cycle of debt.

How to Apply for a Personal Loan?

To apply for a personal loan, follow the 5 steps listed below.

  1. Credit Check. Pull the credit report to assess the borrower's credit score. A higher credit score enhances their chances of approval for a personal loan with the best terms. Wait until the credit is better before applying for a loan.
  2. Manage Debt. Aim to reduce the debt-to-income ratio, as a lower DTI improves loan eligibility. Prioritise paying off debts or increasing the income to lower the DTI if the borrower's DTI is high (around 45% or more).
  3. Compare Lenders. Obtain quotes from multiple lenders to compare APRs, loan amounts, terms, and reputation. Some lenders offer prequalification, allowing borrowers to estimate loan terms without impacting their credit score.
  4. Submit Documentation. Once the lender has chosen the required documentation, such as bank statements or pay stubs, formally apply for the loan. Proof of income or sufficient funds to make payments is needed, primarily if the borrower is employed.
  5. Receive Funds. The lender disburses the funds within a few business days if the loan application is approved. Use the funds for the intended purpose, and consider setting up payment reminders to prevent late charges and protect the credit score.

Who Gives Personal Loans?

Personal loans are given by various financial institutions, including banks, credit unions, online lenders, and peer-to-peer lending platforms. Lenders offer personal loans for many reasons, such as paying off debt, making home changes, going on vacation, and dealing with costs that come out of the blue.

Traditional banks and credit unions offer personal loans to customers who already have accounts with them. They use the customer's credit history and banking history to decide if the customer is eligible. Online lenders are becoming more popular because they make applying for and approving loans quickly and offer low rates easily. Peer-to-peer lending platforms are an alternative to traditional lending channels that let people who need loans directly meet with investors who are willing to lend them money.

Some specialised lenders only work with borrowers with particular credit or groups. Some lenders specialise in giving personal loans to people with little or no credit history. People who need personal loans compare their choices and pick the best loan terms for their needs because there are many lenders to choose from.


What are the Types of Personal Loans?

The types of personal loans are listed below.

  • Unsecured Personal Loans: The loans need no collateral and are based solely on the borrower's creditworthiness. Borrowers receive a lump sum of cash and repay the loan with fixed monthly payments over a specified period.
  • Secured Personal Loans: Secured personal loans require collateral to qualify, unlike unsecured loans. Borrowers pledge assets such as a home, vehicle, or savings account, which the lender seizes if the borrower defaults on payments.
  • Credit-Builder Loans: Credit-Builder loans are designed to help individuals establish or improve their credit history. Borrowers make payments into a lender-held savings account rather than receiving money upfront. The lender reports payments to credit bureaus, and once the loan is repaid, borrowers receive the deposited amount minus any fees.
  • Specialised Lenders' Loans: Some companies, such as retailers or service providers, offer personal loans to customers to finance purchases or services. Loans are convenient but sometimes offer the best rates and terms compared to traditional lenders.
  • Payday Loans: Payday loans are short-term, high-interest loans due on the borrower's next payday. The loans are used by individuals facing immediate financial needs but come with extremely high-interest rates and fees, making them a costly borrowing option.
  • Debt Consolidation Loans: Debt consolidation loans allow borrowers to combine multiple debts into a single loan with one monthly payment. It simplifies repayment and lowers interest rates, saving money over time.
  • Co-Signed Loans: A co-signer with better credit is required to secure a loan in cases where the borrower has a limited credit history or poor credit. Better loan terms are available with co-signed loans because the borrower's and the co-signer's creditworthiness are taken into account.

What are the Requirements of a Personal Loan?

The requirements for a personal loan are listed below.

  • Credit Score and History: Lenders look at credit scores and credit histories to decide if a borrower is creditworthy. Most lenders give a loan if the borrower's credit score is at least 670, but not all do. Some lenders want a better score, while others lend money to people who need a credit history.
  • Income: A steady and sufficient income is essential for getting a loan. Lenders look at applicants' income to ensure they are able to repay the loan. Lenders have different minimum income standards, and the borrower must have a steady monthly income.
  • Debt-to-Income Ratio (DTI): Lenders look at the DTI, which is found by dividing the total monthly debt payments by the gross monthly income. A DTI ratio of less than 36% is ideal, but some lenders accept ratios as high as 50% for very qualified candidates.
  • Collateral: Borrowers must use something as collateral to get a secured personal loan. A home, vehicle, or savings account are all possibilities. Lenders take collateral as protection for the loan and sell it if the borrower doesn't repay it.
  • Origination Fee: Getting a loan is independent of the fee, but many lenders charge it to cover the costs of processing the loan. The fees are between 1% and 8% of the loan amount and are either taken out of the loan money or paid for by the loan itself.
  • Loan Application: Borrowers who want to get a loan must fill out an application that asks for personal information, the amount of the loan, and why the loan is needed.
  • Proof of Identity: Two types of government-issued ID, such as a driver's licence or passport, are needed to make sure the applicant is who they say they are.
  • Verification of Employer and Income: Borrowers who want to apply must show proof that they have a job and cash, such as pay stubs, tax returns, or bank statements.
  • Proof of Address: Lenders need proof of address, such as rent or energy bills, to ensure the applicant lives there.

How Much Is the Interest on a Personal Loan?

The average interest on a personal loan stands at 11.93%, based on a Bankrate study conducted on Feb. 21, 2024. The figure represents an average, and individual borrowers secure rates higher or lower than it based on their financial situation and creditworthiness. Personal loans have surged in popularity as consumers look to consolidate debt and access more favourable interest rates than credit cards.

Personal loan interest is easy to figure out using a formula that considers the loan term, the interest rate, and the principal amount borrowed. The first step for borrowers is to determine the loan's specifics, such as the principal sum, the annual interest rate, and the loan's length in years or months.

A borrower can calculate the total interest due on a personal loan using the formula by multiplying the principal amount by the annual interest rate and the loan term in years. Borrowing £10,000 with an annual interest rate of 5% for a 3-year loan term results in a total interest payment of £1,500.

A borrower's total repayment amount is calculated by adding the principal amount to the total interest. Amortisation is crucial because personal loans are paid back in instalments throughout the loan. The interest component decreases over time, while the principal amount reduces accordingly as payments are made.

Online personal loan calculators help in computing the interest rate. The tools let people who want to borrow money put in information about their loan and get an instant estimate of how much interest and payments cost. Borrowers are able to accurately calculate the interest payable on a personal loan by comprehending the loan details, utilising the correct formula, and considering the repayment structure.

How Can You Pay for The Personal Loan?

You can repay the personal loan by following the due dates specified by the lender. The terms specify how borrowers must repay borrowed cash, including the amount borrowed, the interest rate, the repayment schedule, and any applicable fees or conditions. Understanding and adhering to these terms is critical for meeting financial responsibilities while avoiding penalties or negative credit consequences.

The repayment terms for personal loans vary greatly based on the lender, loan amount, interest rate, and borrower creditworthiness. Borrowers make fixed monthly payments over a certain period until the loan is entirely repaid. The repayment plan ranges from a few months to several years, depending on the loan term selected at the borrowing time.

Payments, such as monthly, bimonthly, or quarterly, cover the principal amount borrowed and the accrued interest. The repayment terms specify how many instalments are required to repay the loan. Borrowers must budget and plan correctly to make loan payments on schedule.

Repayment terms include provisions for fees and penalties, such as late payment or prepayment penalties. Borrowers must carefully consider these terms to understand their financial commitments and prevent potential loan-related fees.

Paying for a personal loan entails complying with the lender's repayment terms, which define the particular circumstances and requirements for returning the borrowed cash throughout the agreed-upon term. Borrowers must comprehend these concepts to manage their finances and repay their debts effectively.

What if You Default on a Personal Loan?

Defaulting on a personal loan has far-reaching consequences, affecting financial well-being. One significant repercussion is the negative effect on credit scores, which hinders the ability to secure future loans, including mortgages and auto loans. The credit damage makes accessing credit at favourable terms challenging, potentially limiting financial options.

Personal loan defaults lead to additional monetary burdens and legal repercussions. A borrower's credit score plummets, making it difficult to qualify for loans or credit cards in the future. Lenders pursue legal action to recoup the outstanding debt, which results in debt collection efforts, lawsuits, or even asset seizure.

Paying back a personal loan on time is very important, as is managing money and being able to afford the payments easily to avoid personal loan default. It involves understanding the loan terms, borrowing only what one is able to repay, and setting up automatic payments to avoid missed deadlines. Talk to the lender immediately if there are money problems and look into options such as deferment or forbearance.

There are things one is able to do to make things better if one needs to catch up on a loan payment or is about to miss a payment. It includes negotiating a payment plan with the lender, consolidating debts to make repayment more manageable, tapping into equity if available, or requesting help from a reputable debt relief company or credit counsellor. The borrower must carefully examine their finances before applying for any loan and ensure they are able to repay it to avoid future financial problems.

Can You Use a Bridging Loan to Pay for The Personal Loan?

No, you cannot use a bridging loan to pay for a personal loan. Bridging loans are designed to provide short-term financing to help people buy a new home while their old one is being sold or to get quick cash for other reasons. Personal loans, on the other hand, are for different purposes and have their own terms and conditions.

Bridging loans are secured against property or assets and are structured differently from unsecured personal loans, with a more extended repayment period. Using a bridging loan to pay off a personal loan is not advisable due to the differences in their nature, terms, and conditions.

Consider each loan type's requirements and purposes before deciding how to spend them. Seek the advice of a financial advisor or lender when choosing between a personal loan and a bridging loan option. They help weigh the options to make an informed decision.

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