How do personal loans work?

If you needed money quickly, where would you turn? While some people have emergency funds or credit cards they can use, others have to borrow to cover an unexpected expense. Personal loans are a common way to get funds without having to use assets, like a car or home, to secure the loan. But how do personal loans work, what's required to get approved, and what alternatives are available?

How do personal loans work?

Personal loans provide a lump sum of cash that can be used for any purpose. Whether you're consolidating credit card debt, paying for medical procedures, starting a business, or improving your home, a personal loan can get you money quickly without requiring collateral for the loan.

• Loan amounts: The maximum amount you can borrow with a personal loan varies by lender, but can be as high as $100,000.
• Personal loan interest rates: Most personal loans come with fixed interest rates. As of May 2025, the average interest rate is 12.26%, but rates vary based on your credit, loan amount, and repayment term.
• Repayment period: Loan terms typically range from 12 to 84 months and consist of fixed monthly payments. Shorter terms often come with lower interest rates, while longer terms usually carry higher rates to compensate for a higher default risk. 
• Collateral: Most personal loans are unsecured and don’t require collateral—approval is based on your credit, income, and other factors. Some lenders offer secured personal loans backed by assets such as savings accounts, investment accounts, car titles, pawned items, or home equity.
• Additional fees: Some lenders charge underwriting, credit check, or origination fees, which can increase your loan’s annual percentage rate (APR) above the base interest rate. Others offer no-fee loans, so it’s important to compare APRs to understand the true cost of borrowing.

Reasons to get a personal loan

There are many reasons you may need to get a personal loan, and everyone's personal finances are different.

• Debt consolidation. Credit card debt can be challenging to pay off, especially when interest rates are rising. A debt consolidation loan combines your credit card balances into one loan with a fixed monthly payment and a fixed interest rate.
• Small home improvements. Getting a home equity loan or line of credit can take weeks, and some homeowners don't have enough equity to get approved. A home improvement personal loan can help borrowers tackle smaller home improvement projects.
• Starting a business. Banks typically don't lend to new businesses, so entrepreneurs usually rely on their personal finances to borrow money. As your business grows, you can repay the debt and replace it with a small business loan.
• Paying for a wedding. Once-in-a-lifetime experiences can be expensive. A personal loan can provide the money you need to create your dream wedding today, while paying it off over time.
• Medical or healthcare procedures. Many healthcare providers require payment up front before providing their services. A personal loan can help you get the medical care you need today while you haggle with insurance for coverage or pay for the procedure over time.
• Emergency or unexpected expenses. The average household may struggle to pay for unexpected expenses without going into debt. While everyone should have an emergency fund for these situations, a personal loan can provide the necessary cash to cover these expenses.

Personal loan requirements

When applying for a personal loan, lender requirements can vary widely. The verification procedures and requirements may also be different when applying online, over the phone, or in person.

Here are a few of the requirements that your lender may have before approving a loan.

• Proof of identity. A government-issued photo ID, such as a driver's license, passport, or military ID.
• Proof of address. Bring a copy of your mortgage statement, signed lease agreement, utility bills, or other official documents that can prove you live at your address.
• Employment verification. Have a paycheck stub and the number to your manager or payroll department.
• Credit score. The lender will pull your credit history through its system, but it is helpful to know your credit score ahead of time. This allows you to take steps to improve your score and focus on lenders who target borrowers with similar scores.
• Debt-to-income ratio (DTI). This is the ratio of your minimum monthly payments versus your gross income. Gross income is your total wages before taxes and other deductions. Existing debts include mortgages, auto loans, credit cards, student loans, and other debt, but exclude household expenses, utilities, and other bills.
• Loan purpose. Some lenders may request how you'll spend the money as a condition of their approval.

Tips for personal loans

If you're ready to apply for a personal loan, follow these tips to give yourself the best odds of getting approved.

• Boost your credit score. Check your credit report to fix any errors. Pay down your revolving debt to reduce credit utilization. Make all payments on time to avoid late fees and negative marks on your credit.
• Prepare your financial information. Assemble copies of your latest paycheck stubs, bank statements, and tax returns to speed up the loan process. Many lenders offer instant approval online based on your application, credit score, and other publicly available information.
• Understand lender requirements. Research lender criteria to find lenders that match your financial situation. Consider a lender's credit score requirements, debt-to-income ratios, and minimum income.
• Compare rates and terms. Review interest rates, fees, and other terms across multiple lenders to find the best personal loan for your situation. Some lenders allow borrowers to prequalify without impacting their credit score.

Alternatives to personal loans

Personal loans are a good choice to cover large purchases, consolidate debt, or when you need extra cash. However, they aren’t the best borrowing option for every situation. Before submitting your personal loan application, consider these financing alternatives.

Personal credit card

Credit cards are a common payment option to cover regular household expenses and unexpected purchases. If you pay off your balance in full each month, you’ll avoid costly interest charges. However, when you carry a balance from one month to the next, credit cards can be an expensive way to finance purchases. For this reason, credit cards are best for low-expense, short-term financing.

Some credit cards include 0% or low-cost intro APR offers for new and existing customers. These promotions often last for 12 to 21 months and may include purchases, balance transfers, or both, depending on the card. 

Home equity loan

A home equity loan operates like a personal loan, but it is secured by the equity in your home. These loans typically have repayment periods ranging from 5 to 30 years. However, you can usually pay them off ahead of time without a prepayment penalty. Interest rates tend to be lower than those of personal loans and credit cards. 

The maximum loan amount depends on your home's value and how much you owe on your mortgage. Banks usually cap loan amounts at 80% to 90% of your home's equity minus your mortgage balance. For example, a bank offering 90% LTV (loan-to-value) on a $400,000 home with a $250,000 mortgage would lend up to $110,000 through a home equity loan.

Home equity line of credit

Home equity lines of credit (HELOCs) are flexible lines of credit secured by your home. You can borrow any amount up to your credit limit, and you’ll only pay interest on what you borrow during the 5 to 10-year draw period. As you repay your HELOC balance, you’ll open up additional credit that can be used at a later date. Once the draw period ends, you’ll have principal-plus-interest monthly payments over a 10 to 20-year term. HELOCs have variable interest rates, which impact your monthly minimum payment. 

Home equity investment

A home equity investment (HEI) is a way of tapping into your home’s equity without adding another monthly payment to your bills. You’ll receive a lump sum of money based on your home’s value and existing mortgages, up to $500,000. Rather than monthly payments, you’ll repay the money plus a portion of your home’s appreciation when you sell, refinance, or use another source of funds over a flexible 30-year term.

With an HEI, you don’t need to prove income, and it’s available to homeowners with less-than-perfect credit.

Cash secured loan

A cash-secured loan is a personal loan backed by the borrower’s assets. The assets securing the loan may vary in type and substance, but may include certificates of deposit (CDs), investments (stocks, bonds, or mutual funds), or other liquid assets. Some lenders may allow you to borrow against vehicles, paintings, crypto, and other non-traditional investments.

Frequently asked questions

How is a personal loan paid to you?

Proceeds from personal loans are typically deposited in your linked bank account shortly after getting approved. Some lenders may deliver the money directly to other creditors (think debt consolidation), pay a retailer (buying furniture, paying for medical care), or issue a cashier’s check.

What are the disadvantages of a personal loan?

Personal loans can negatively impact your finances in multiple ways. The fixed monthly payments do not offer flexibility, so you may incur late fees, penalties, and negative credit marks if you cannot make the payments. Unsecured personal loans also tend to have higher interest rates, which lead to larger monthly payments. And for those taking out a debt consolidation loan, if you don’t correct the overspending behavior, you may end up with maxed-out credit cards again.

How much would a $5,000 personal loan cost a month?

The minimum monthly payment on a $5,000 personal loan varies based on the interest rate and loan term. Extending the loan term may lower the payment, but you’ll pay more interest over the course of the loan. The average interest rate on a personal loan is 12.26%, but it may change based on your credit score, loan amount, and loan term. At the average interest rate, the monthly payment is $111.88 on a five-year personal loan.

Is taking a personal loan a good idea?

A personal loan can be a good idea when the money is used to pay off high-interest debt, invest in a small business idea, or cover an unexpected expense. With fixed monthly payments, you'll pay off the loan at the end of the loan term. Personal loans also offer fixed interest rates, which means your payment won't increase if rates go up while paying off your loan.

The bottom line

Now that you know how personal loans work, you can make an informed decision if they are the best option for your borrowing needs. Personal loans offer a lump sum of money at a fixed interest rate that is repaid with a fixed monthly payment for a defined period of time. 

They are usually unsecured, but you may use assets as collateral to receive a lower interest rate or increase your approval odds. If a personal loan isn't right for you, many alternative financing options are available, including credit cards or using your home's equity.

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