Types of Personal Loans: Definitions and Uses

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Updated: May 31, 2024

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Personal loans offer you more flexibility in how you can use the funds. You can consolidate high-interest debt, make home improvements, cover unexpected medical expenses or fund a large purchase.

There are different types of personal loans tailored to specific purposes. Exploring each type will help you understand your options and choose the one that best suits your circumstances.

Key Takeaways

The beauty of a personal loan is that you can use the funds for various purposes, like paying off existing debt, taking a long-awaited vacation or starting a business.

Some of the most common types are secured and unsecured personal loans. Debt consolidation loans and co-signed loans are also options.

Avoid payday loans, pawnshop loans and title loans. They have high costs and other risks that can lead to a cycle of debt accumulation.

Secured Personal Loans

Secured personal loans require collateral to secure the funds borrowed. Collateral is a guarantee to lenders that you will repay your loan, reducing their risk in case you default. Common collaterals accepted include real estate, vehicles, insurance policies or savings accounts.

Secured personal loans are typically offered by banks, credit unions and online lenders. These loans often come with higher borrowing limits. They are more accessible if you have a lower credit score or don't qualify for unsecured loans. Note that the application process can be more rigorous, as lenders typically require a more thorough evaluation of your net worth.

If you fail to repay a secured personal loan, the lender could seize and sell the collateral to recover its losses.

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The requirements to apply for a secured personal loan include:

  • Proof that you own your collateral: Your lender wants to ensure that what you're using to secure your loan is your property. Typically, using bank accounts as collateral is easier since ownership is easy to verify.
  • Proof of financial status: This can include your income and bank statements. Some lenders require you to earn a specific amount annually to qualify for a loan.
  • Credit score: Each lender has different credit score requirements, which tend to be lower for secured loans.

Unsecured Personal Loans

Unsecured personal loans don’t require collateral to secure the loan. Instead, lenders use the borrower's creditworthiness and financial background when deciding whether or not to approve the loan. Determining factors include credit score, income stability, employment history and debt-to-income ratio.

With an unsecured personal loan, you avoid the risk of losing your asset if you default on the loan. The application process is also faster and simpler, making these loans a convenient option if you need quick funds. However, unsecured personal loans may have higher interest rates and lower borrowing limits. Missing payments can also have severe consequences, including damage to your credit score and potential legal action by the lender to recover outstanding debt.

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It’s wise to look into the following factors if you’re applying for an unsecured personal loan:

  • Credit score: Your credit standing gives lenders an idea of how well you manage debt. A higher score suggests you are a less risky borrower, possibly resulting in lower interest rates.
  • Verifiable income: Lenders need to know you have a steady source of funds to repay your loan. Most application processes require you to submit documents about your financial standing, which may include bank accounts and pay stubs.
  • Debt-to-income ratio (DTI): Lenders determine the level of your financial health from the portion of your income that goes into debt repayment. A good DTI ratio is 36%, but you'll be better off with a lower ratio.

Co-Signed Personal Loans

You might consider a co-signed loan to access financing if you have a limited credit history or a low credit score. A co-signer is typically someone with a strong credit history and stable income, providing reassurance to the lender. They increase the likelihood of loan approval and potentially secure better loan terms for the primary borrower.

A co-signer on a loan application acts as a guarantor and agrees to repay the loan if you default. As such, you should carefully consider who your co-signer will be. This person should have good or excellent credit standing, a low debt-to-income ratio and enough earnings to pay your monthly due.

Note that defaulting on the loan can have severe consequences for both parties, including damage to credit scores and a strained relationship between you and your co-signer.

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If any of the items below describe your situation, having a co-signer may be a good option.

  • You have a less-than-stellar credit standing: If your credit score doesn't meet a lender's minimum requirement, you may sometimes need a co-signer to continue with your application. In other situations, your lender may offer you loan options even with a fair credit score. However, you may get higher interest rates with a lower credit score.
  • You have limited or no credit history: If you don’t have enough credit history to satisfy a lender’s requirements, a co-signer on your application is helpful.
  • You don’t meet income requirements: Some lenders require borrowers to earn a specific annual income to qualify for a loan. If your earnings fall short, you can ask someone with a higher income to co-sign your application.

Debt Consolidation Personal Loans

Debt consolidation loans exist to help individuals manage multiple debts more efficiently. These loans allow you to combine various high-interest debts, such as credit card balances, into a single, more manageable loan with a potentially lower interest rate.

Interest rates on debt consolidation loans are often lower than credit card interest rates. For example, the average interest rate for credit cards is 21.59% as of February 2024, while the average rate for personal loans is 12.49% based on Federal Reserve data.

In addition to simplifying finances and saving money on interest payments, debt consolidation loans can also improve your credit score by reducing your credit utilization ratio and demonstrating responsible debt management to creditors.

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If you are considering consolidating your existing debts into one loan, you must prepare the following:

  • Proof of identity and residence: Most debt consolidation loans require borrowers to be at least 18 years old and U.S. citizens. Some loans are only available to borrowers who live within a specific area.
  • Detailed information on current debts: You’ll need to outline your current debts, where they are held and how long you’ve had them.
  • Proof of income: You must have verifiable income to show the lender you can repay the loan.
  • Proof of financial health: Your credit report and history indicate how well you manage debt. Responsible borrowers typically have better credit scores.
  • Acceptable debt-to-income ratio: A lower DTI ratio shows that you can keep up with your new debt terms.
  • Equity: If your loan amount is significant, you may be required to put up collateral.

Personal Lines of Credit

Personal lines of credit (PLOCs) are structured differently than traditional personal loans. Interest is only charged on the amount you borrow from the credit line, and you can continually access funds up to your predetermined credit limit as long as you make timely payments.

PLOCs are ideal for covering unexpected expenses, managing cash flow fluctuations or financing ongoing projects where the total cost is uncertain. You can withdraw funds as needed and repay them over time, making PLOCs a convenient option if you require periodic access to funds without committing to a lump-sum loan.

Note that you can face penalties for making late payments or exceeding your credit limit. PLOCs may also require collateral or a strong credit history to qualify, limiting their accessibility.

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Since most personal lines of credit are unsecured, lenders approve your application based on your creditworthiness and ability to pay. You must have these things to qualify:

  • Credit score and history: The higher your credit score, the more likely lenders will approve your application and offer better rates. Your credit history indicates how well you can manage debt.
  • Income: Most lenders require you to show proof of income. They use it as evidence that you can repay the amount you borrow.
  • An existing account: Getting a personal line of credit is often easier if you use a lender with which you have a good history. Well-managed savings or checking accounts lower your level of risk. Keeping a significant amount in your account may make you eligible for specific discounts.

Fixed-Rate Personal Loans

Fixed-rate loans are a type of personal loan where the interest rate remains constant throughout the loan term. This means your monthly payments remain the same, making budgeting easier and providing stability. These loans also protect you from interest rate fluctuations, as the rate remains constant regardless of changes in the market.

Although the fixed interest rate provides stability, it may be initially higher than variable rates. You may also face penalties for early repayment or refinancing, limiting flexibility.

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If you prefer to secure a fixed-rate loan, preparing these can help ensure you will qualify:

  • A good credit score: Fixed-rate loans tend to have higher interest rates than variable-rate loans. Lenders typically offer lower interest to borrowers with good or excellent credit scores.
  • Debt-to-income ratio: Lenders want assurance your current debts don't exceed your ability to make payments. A lower debt-to-income ratio may help you get your loan application approved.
  • Proof of income: Lenders look at your income to see whether you can repay your loan. Some have minimum requirements for your annual earnings, so it's best to clarify these with your lender even before you begin the application process.

Adjustable-Rate Personal Loans

Unlike fixed-rate loans, where the interest rate remains constant, adjustable-rate loans or variable-rate loans have interest rates that change based on market conditions. This means that there may be changes in your monthly payments as interest rates rise or fall. Personal loans don’t usually come with adjustable rates unless they’re auto loans.

Adjustable-rate loans offer flexibility and potentially lower initial interest rates than fixed-rate loans. These features make them attractive to borrowers seeking lower upfront costs or planning to refinance. However, fluctuating interest rates can lead to unpredictable monthly payments, making budgeting challenging. You may also face higher monthly payments if interest rates rise, increasing financial strain.

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It's best to have the following requirements to qualify for an adjustable-rate loan:

  • Credit history: Everything on your credit report is part of your credit history. It shows lenders how well you can manage various debts.
  • Credit score: Your credit score is tied to your credit history. The higher your score, the more likely lenders will approve your loan. A good score may also qualify you for lower rates.
  • Verifiable income: You need to show lenders that you can repay your loan, which involves your verifiable income. Some lenders require a specific amount, but this varies.
  • Debt-to-income ratio: The higher your ratio, the less likely you can afford a new loan — making you riskier to lenders. Ideally, you should keep your debt-to-income ratio at 36% or lower.
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Personal loans can come with certain extra fees:

  1. Origination Fees: This is a one-time fee charged by lenders to cover the cost of processing the loan. It’s typically a percentage of the loan amount, ranging from 1% to 6%. The origination fee is usually deducted from the loan proceeds.
  2. Late Fees: If you miss a payment or make a payment after the due date, the lender may charge a late fee. The amount can vary by lender, but it’s often either a flat fee or a percentage of the payment due.
  3. Prepayment Penalties: Some lenders charge a fee if you pay off your loan early. This is known as a prepayment penalty or prepayment fee. The rationale is that lenders expect to earn a certain amount of interest over the life of the loan.

Not all lenders charge prepayment penalties, so if you think you might want to pay off your loan early, it’s worth shopping around for a lender that doesn’t have a prepayment penalty. — Alvin Yam, CFP

Personal Loans to Avoid

Not all personal loan options are created equal. Some types of personal loans come with high costs and added risks — it’s best to avoid them if you can. Here are a few to watch out for:

  • Credit card advance: With a credit card advance, you can withdraw cash from your credit card. However, this option comes with very high interest rates and extra fees, often leading to a cycle of debt accumulation.

  • Payday loan: Payday loans provide quick access to small amounts of money for various purposes, typically due on your next payday. Despite their convenience, payday loans have extremely high interest rates and short repayment periods. Borrowers often struggle to keep up with repayment demands, facing exorbitant fees and penalties that worsen their medium and long-term financial situation.

  • Pawnshop loan: Pawnshop loans involve borrowing money by using valuable possessions as collateral, such as jewelry or electronics. However, you risk forfeiting your items for a fraction of their value if you can’t repay the loan.

  • Title loan: With a title loan, you use your vehicle's title as collateral to secure a loan, typically at high interest rates. Title loans are a risky and costly borrowing option, and you risk losing your vehicle if you fail to repay the loan.

FAQ: Types of Personal Loans

We answered some frequently asked questions about the types of personal loans available to help determine which one is the best option for you.

Are personal loans secured or unsecured?
What's the difference between fixed-rate and adjustable-rate loans?
How can I consolidate debt with a personal loan?
Can I use a personal loan for home renovations?
Are personal loans a good option for emergency expenses?
How long does it take to get approved for a personal loan?
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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

Editorial Disclosure: Opinions, reviews, analyses and recommendations are the author’s alone and have not been reviewed, endorsed or approved by any bank, lender or other entity. Learn more about our editorial policies and expert editorial team.