5 Things You Should Know About How Personal Loans Work Before Applying

Mortgages pay for home, auto loans pay for vehicles, but personal loans can pay for just about anything.

Like most financial products, personal loans have both good and not-so-good features. Here, we cover how personal loans work and what you should know before applying. The better prepared you are, the more likely you are to have a positive experience.

1. How a personal loan works

Personal loans are a type of installment credit. After your loan application is approved, the lender will deliver a one-time payment. Typically, this payment is directly deposited into your bank account. You're then responsible for paying the loan back through installments (typically, monthly payments are due).

The length of the loan is referred to as the "term." It's how long you have to pay the loan off in full. The APR is the amount of interest plus other fees you will be charged for borrowing the money.

Most personal loans can be used for any purpose. For example, to remodel a home, make car repairs, pay for a wedding, or consolidate debt.

2. The higher your credit score, the lower your interest rate

The majority of personal loans require no collateral. That means the lender is lending you money based on your promise to pay alone. Since the lender carries all the risks, it will base the final APR you pay on how risky it perceives your loan to be. The higher your credit score, the more confident the lender will be that you will repay the loan. After all, your credit score indicates how you have managed debt in the past.

The lower your credit score, the riskier your loan appears to be and the higher your APR is likely to be. If your score is low, you're also likely to be approved for a loan with fees, something those with a higher credit score can typically avoid. While your personal loan may cost more, if you're using it to pay off debt carrying an even higher APR, you might be money ahead.

3. Some personal loans are more forgiving than others

If you've just graduated from college, there are some lenders who forgive the fact you have a thin or nonexistent credit history. There are other lenders that allow you to defer payments if you lose your job.

4. Fees eat into your personal loan

If possible, it pays to avoid loans charging fees for things like loan origination, administration, and prepayment penalties. Here's how those fees work: Let's say you're borrowing $15,000 and loan fees amount to $1,500. Before cutting you a check, the lender will deduct $1,500 from the amount you're borrowing. That means that $13,500 will land in your bank account rather than $15,000. Still, you're responsible for repaying the entire $15,000, plus interest.

5. Shopping around is key

Not all lenders are created equal. One may quote you an APR of 7% while another quotes 9%. Most personal loan lenders run only a soft credit check before telling you whether your application has been approved, and if so, how much your APR will be. That's good news because it means you can shop as many lenders as you'd like without dinging your credit score.

The caveat is that a few lenders do run a hard credit check, so be sure to ask before submitting an application.

The sheer versatility of personal loans makes them an attractive financial tool. Before you apply for a loan, though, be sure to read the fine print to know what you're committing to.