The Beginner’s Guide to Personal Loans

How do personal loans work?

Personal loans involve an application and review process to determine eligibility and specific terms. They are generally unsecured, meaning that they don't require you to put up any assets as collateral, like a house or cash deposit. This makes them distinct from secured loans, such as mortgages, auto loans, or home equity lines of credit (HELOCs), which are backed by property. Instead, lenders look at your credit and overall financial situation to determine whether you qualify for a personal loan. 

This means more risk for the lender, which in turn means interest rates on personal loans are usually higher than on secured loans (but are often still more favorable than credit cards). On the bright side, they also tend to lend out the money faster, typically within 1 to 4 business days. Plus, while there are a few restrictions, you can use this money for almost anything. 

What does the loan approval process look like?

To evaluate you for a loan, lenders will typically ask for verified personal and financial information. This typically includes your: 

• Identification and contact details
• Social Security number (SSN)
• Employment and income details (like pay stubs, W-2s, or tax returns)
• Credit score and history

If you apply with a co-signer, like a partner or parent, they’ll also be evaluated using the same criteria. A strong co-signer can help you qualify or secure a lower rate, but be aware that they’ll be equally responsible for repaying the loan.

How much can be borrowed, and for how long?

Your maximum personal loan amount and term depend on what you request, your profile evaluation, and the lender’s limits. Based on these factors and state regulations, lenders typically offer loan amounts between $1,000 and $50,000, though some go as high as $100,000+ for exceptionally qualified borrowers. 

Terms typically range from 1 to 7 years, with certain lenders offering 10+ years depending on the purpose. Generally, shorter terms mean higher monthly payments but lower overall interest costs, while longer terms mean smaller monthly payments but a higher interest cost over the life of the loan. 

Also, note that the terms and amounts of the loan can affect its interest rate. Smaller loan amounts and shorter repayment terms generally mean the lender takes on less risk, which can result in lower rates.

What are the interest rates and fees?

Interest is one of the most important factors to consider when taking out a loan. Most personal loans come with fixed interest rates that are determined by your credit score and The Wall Street Journal ^® prime rate plus a margin. However, some lenders offer promotional rates under certain circumstances, like for new clients. The interest rate you pay can vary widely based on your lender and application criteria, with rates currently ranging from around 6% to 36% for most borrowers.

Other factors to consider when applying for a loan are the various fees you may be required to pay once approved. These can include:

• Origination fee: A one-time fee charged for processing a loan application, sometimes referred to as an application fee. It typically ranges from 0.5% to 1% of the loan amount, although some lenders may charge more or waive it entirely.
• Late payment fees: Fees added to your loan if you miss a payment. Some lenders charge a flat amount, while others charge a percentage of the payment amount.
• Prepayment penalties: Fees incurred for paying your loan off sooner than agreed upon. These penalties are less common in personal loans, but not unheard of.

Note that the total annual cost of borrowing money is known as your annual percentage rate (APR). It includes your interest rate plus associated fees, making it the most effective metric to compare offers across lenders.

Can you pay a personal loan off early?

Most lenders offer the option to repay your loan early without penalty, but some may charge a prepayment fee. So, it’s critical that you carefully review your loan agreement.

That said, if you come into some extra money, it could be a good idea to pay off your loan sooner to save on interest costs. Options might include increasing monthly payments, making extra payments (i.e., biweekly or occasional lump sums), or even paying out the balance in full before your term is up.

Common uses for personal loans

While personal loans are flexible and can be used for all sorts of purposes, borrowers tend to use them for major expenses or financial needs that aren’t covered by savings. Common uses include:

• Consolidating high-interest debt, such as credit card balances
• Paying for a wedding
• Funding home renovations or repairs
• Covering moving costs
• Covering medical bills or emergency expenses
• Making other large purchases

What shouldn’t a personal loan be used for?

While they have many legitimate uses, personal loans generally cannot be used for:

• Student loans
• Down payments on mortgages
• Starting or funding a business (business loans have separate criteria)
• Investments like stocks, securities, or cryptocurrencies
• Other high-risk uses (i.e., gambling)

Loan terms and restrictions vary by lender, so it’s important to review each option carefully.

What are the types of personal loans?

From lender to lender, the types of personal loans available can differ, but most fall into a few key categories. These include:

• Unsecured loans: Loans that aren’t backed by collateral like a house, vehicle, or savings account. Approval is based mainly on your credit profile, income, and debt-to-income (DTI) ratio. Most personal loans are unsecured.
• Secured loans: Loans that are backed by collateral, meaning if you default, the lender can take possession of those assets to help recover what you owe. Secured personal loans are much less common, but some lenders do offer them.
• Fixed-rate loans: Loans with an interest rate that doesn’t change across the entire term, even if the market changes. This means your monthly payments and total interest cost remain consistent and predictable. Most personal loans have fixed rates.
• Variable-rate loans: Loans where the interest rate fluctuates based on a benchmark rate (usually the prime rate). This means your payment amount and interest can change during the term.
• Debt consolidation loans: Loans designed to combine multiple debts into one, ideally with a lower rate and a single fixed monthly payment.
• Co-signed loans: Loans that involve a primary borrower and a co-signer who agrees to take responsibility for repayment if the borrower cannot or will not pay. A strong co-signer can help you qualify or secure better rates.
• Joint loans: Loans taken out by two borrowers together. Unlike co-signed loans, both applicants are primary borrowers and share equal responsibility for repayment.
• Credit-builder loans: Loans designed for people looking to build or rebuild credit. Funds are deposited into a secured account and are only released once the loan is paid off.

Note that a single personal loan may belong to multiple categories. For example, you might have an unsecured fixed-rate loan or a joint debt consolidation loan.

The pros and cons of personal loans

No matter how much money you borrow, taking out a personal loan is a major financial decision. As such, it’s important to weigh the pros and cons before moving ahead. 

Advantages

• Fixed repayment schedule: Personal loans usually have fixed monthly payments over a set term, which can make them easier to budget for. This differs from revolving credit (such as lines of credit), where payments often fluctuate.
• Funds are available quickly: Depending on your lender, once your personal loan is approved, you can receive the money in full within a few business days.
• Flexible uses: Unlike loan options that are dedicated to specific purposes like student or auto loans, personal loans can be put towards a wide range of expenses, from medical bills to large purchases.
• Lower interest rates than credit cards: While personal loan rates vary based on evaluation criteria, they are typically lower than credit card APRs. Personal loans can offer single-digit interest rates, whereas credit card rates are often upwards of 30%.
• No collateral required: In most cases, you don’t need to put down a property or vehicle to secure a personal loan, reducing your risk.

Disadvantages

• Extra fees: Personal loans may include origination fees, late or missed payment fees, or prepayment penalties.
• Possible impact on credit score: Mismanaging a personal loan by missing payments or taking on too much debt can have a negative impact on your credit score. (On the flip side, making on-time payments can help improve your score.)
• Not ideal for long-term borrowing: Unlike mortgages, home equity loans, or lines of credit, personal loans typically have higher interest rates and shorter repayment periods. This makes them less suitable for larger or longer-term financing needs.
• High rates for weaker credit: If your credit score or history isn’t strong, you might face steep interest rates that can make borrowing less affordable.

How personal loans differ from personal lines of credit

When figuring out which type of loan is right for you, you might also be considering a line of credit. Like a personal loan, a personal line of credit can also give you access to the money you need, but there are a few key differences to be aware of. 

The biggest difference is that while a personal loan offers a fixed lump sum, a personal line of credit lets you borrow only as much as you need, up to a preset limit. You only pay interest on the amount you borrow and can reuse the credit as you repay it.

For projects like home renovations where exact costs can be uncertain, a line of credit might be a good option. On the other hand, personal loans provide more stability for one-time expenses given their fixed payments and locked-in rates.

This side-by-side comparison can help you determine which loan type is right for you:

Other financing options to consider

If you still aren’t sure if a personal loan is right for you, there are a number of other borrowing options you can consider, which vary by eligibility. Examples include:

• Home equity lines of credit (HELOCs): If you own a home and have built up equity, a HELOC lets you borrow against that equity.
• Home equity loan: A home equity loan is also secured against the equity in your home. Unlike a HELOC, however, this type of loan provides a lump sum with a fixed interest rate and predictable monthly payments.
• Credit cards: Credit cards allow for easy and convenient access to funds and may provide rewards or welcome offers, but usually come with higher interest rates.

Tips for using a personal loan responsibly

Loans can impact your credit score and future borrowing ability, from renting an apartment to qualifying for a mortgage. Suffice to say, it’s important to be responsible, especially because easy-to-make mistakes have far-reaching consequences. Late payments, for example, can seriously reduce your credit score and will remain on your credit report for seven years.

Here are a few tips to stay on track:

• Create a realistic budget and only borrow what you need
• Set up automatic payments from your bank account to avoid late fees
• Keep an emergency savings buffer if possible

Pitfalls to avoid

In the same vein, here are some common mistakes to watch out for when taking out a personal loan:

• Over-borrowing beyond your means
• Signing for a loan without evaluating all lenders and lending options
• Missing or skipping payments

Personal loans are a personal decision

Whether it’s for a new car, wedding, or trip abroad, a personal loan can be a great way to access the funds you need. If you’re a BMO client, you’ve got plenty of options to make borrowing convenient and cost-effective. Just remember to evaluate the pros and cons, look at your overall financial picture, and borrow only what you can comfortably pay back.

If you’d like to learn more or explore next steps for a personal loan, you can visit a BMO branch, reach out online, or speak with an expert at 1-888-340-2265.