Types of Personal Loans: Definition & Uses
Updated: September 26, 2023
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With a personal loan, you borrow a specific amount from a lender, which you can use for various reasons. You could fund a wedding, purchase a new appliance, or pay medical bills. Although some lenders restrict how you use your funds, most don't.
Common types include unsecured, secured, debt consolidation and co-signed loans. Personal debt in the U.S. increased by 5.9% from 2020 to 2021, so this is a topic relevant to many Americans. MoneyGeek's guide explores the different types of personal loans and can help you decide which may fit your needs.
Secured Personal Loans
The first type of personal loan on our list is a secured one. A secured loan requires you to put something up as collateral — an asset used to back your loan. Examples of possible collateral are real estate, cars, boats, stocks or insurance policies. Typically, your collateral's value should be higher than your loan amount. The possibility of losing your asset is a motivation to pay your loan.
Various financial entities, such as banks, credit unions or online lenders, offer secured personal loans. Typically, secured loans are the best type when you want to borrow a significant amount. Despite the higher loan amount, they're often easier to get than an unsecured one because lenders are less at risk.
Borrowers with less than stellar credit standing may be more likely to get approval if they apply for a secured loan. This loan type could benefit someone trying to rebuild credit. Lenders generally charge lower interest rates for these types of personal loans, so it's often better for borrowers on a budget.
Despite the advantages, not paying your loan opens the possibility of losing your property. That's one of the primary considerations before pursuing this type of personal loan.
If you want to apply for a secured personal loan, you'll likely need the following:
- Proof that you own your collateral: Your lender will want to ensure that what you're using to back your loan is your property. Typically, it's easier to use bank accounts as collateral 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. However, they tend to be lower for secured loans.
Unsecured Personal Loans
Any personal loan that does not require you to put in an asset as collateral is unsecured. Unsecured loans may also be known as term loans or installment loans because your loan agreement specifies a specific duration for repayment and a predefined monthly payment.
Since there’s no collateral, lenders use your creditworthiness and financial standing to gauge whether you can repay your loan. Interest rates for unsecured loans also tend to be higher than secured ones, so you may pay more each month.
You may also need higher credit scores, although different lenders have varying minimum requirements. For example, Best Egg requires a credit score of 700 or higher to get competitive rates. Avant, on the other hand, only requires 600.
Unsecured personal loans have few restrictions regarding fund usage. Usually, the only uses prohibited are gambling and illegal activities. However, some lenders do not allow you to use your funds for secondary education expenses.
The advantage of getting an unsecured personal loan is your lender can’t take your property if you can’t repay the loan. Most borrowers apply through banks, but credit unions and online lenders also offer unsecured personal loans.
It’s wise to look into the following factors if you’re applying for an unsecured personal loan:
- Your 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. These may include bank accounts and pay stubs.
- Debt-to-income ratio: 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 the lower it is, the better off you'll be.
Co-Signed Loans
Not all borrowers qualify to apply for a loan independently. In some situations, you might need another person to co-sign. A co-signer may increase your chances of getting your application approved. Another advantage is it may result in lower interest rates and better loan terms.
When a person agrees to co-sign your loan application, they choose to assume the responsibility of repaying your loan if you cannot. Some consider co-signing for a loan a generous act because although they won’t have access to the funds your lender releases, they can be held liable for the debt.
It's best to be careful when choosing a co-signer. Ideally, this person should have good or excellent credit standing — a credit score of 700 or higher would be best. Select someone with a low debt-to-income ratio who earns relatively well (at least enough to pay your monthly due).
Despite the benefits of a co-signed loan, it also comes with risks. When your loan application is approved, the debt appears on both your credit reports. How you manage the debt affects both of you. Payments made on time can increase your credit score, while late or missed payments may pull it down.
Not everyone needs to have a co-signer on their loan. However, if any of the items below describe your situation, it may be a good option.
- You have a less-than-stellar credit standing: Sometimes, your credit score doesn't meet a lender's minimum requirement, so you may need a co-signer if you want to push through 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.
- You have limited or no credit history: Sometimes, you don’t have enough credit history to satisfy a lender’s requirements. In these situations, 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 Loans
Juggling multiple debts, such as several credit cards carrying balances, isn't easy. Most borrowers have an easier time if they deal with one loan only, and that's where a debt consolidation loan can help. You can pay off existing debts using the funds, only leaving you with one payment, making it easier to manage.
Debt consolidation may be more cost-effective if you use them to pay off your credit card balances. The average credit card interest rate for the first quarter of 2022 is 14.56%, while it's only 9.41% for a personal loan.
Your credit score may also benefit from a debt consolidation loan. It’ll lower your credit utilization and increase your credit mix, contributing factors to your FICO score calculation.
If you have existing loans, you can check with your lender to find out if a debt consolidation loan is one of the types of personal loans they offer. It’s also smart to compare rates from multiple providers to ensure you’re getting a good deal.
Borrowers who are considering consolidating their existing debts into one loan 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 are only available to borrowers who live within a specific area.
- 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 are good indicators of how well you manage debt. Responsible borrowers typically have better credit scores.
- Acceptable debt-to-income ratio: A lower DTI ratio shows that you’re not so far into debt that repaying them is a challenge.
- Equity: If your loan amount is significant, you may be required to put up collateral.
Personal Line of Credit
Unlike the other types of personal loans, a personal line of credit (PLOC) is distinct. A PLOC has a credit limit you can access through a debit card or check. You can even request your lender to transfer your funds to another account electronically. Most are open-ended, but some lenders establish defined draw and repayment periods.
A personal line of credit is revolving debt and is reusable. You receive a monthly statement from your lender, showing how much you owe based on your spending and interest. Once you've repaid it, you can borrow it again.
Some people prefer this type of personal loan over cash advances because lenders don't charge you a fee each time you borrow. However, you may have to spend an annual fee to keep the account open. Interest rates are also lower. Although it varies between lenders, you may find one as low as 10% with good credit scores. That's still less than the average credit card interest of 14.56%.
PLOCs are best for emergencies, such as unforeseen home repairs or medical bills. You can also use them for long-term projects or trips. However, there are limitations for funds usage, such as for investments or business purposes.
You can check with your existing lender if they offer it. You can check with other banks, credit unions and online lenders if they don't.
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 is, the more likely lenders will approve your application and offer you 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 Loans
The term fixed-rate refers to the way your lender calculates your interest. You lock this in during the application process and your lender charges you the same rate for the duration of your loan. Having fixed interest means whatever you pay each month in your first year will be the same in your last year. A fixed-rate personal loan may be best if you want predictability in your monthly payments.
A personal loan, regardless of the terms, is a commitment. It’s important to ensure you can keep up with the monthly payments, so knowing what you can afford to pay in advance can help with your budget. Most lenders, including banks, credit unions and online lenders, offer fixed-rate personal loans.
You can use the funds from a fixed-rate personal loan on most expenses. Some lenders might have restrictions, like college or postsecondary school tuition or gambling. You likely won’t encounter any challenges if you use it to acquire new appliances or consolidate your debt.
A fixed-rate personal loan means your interest isn't affected by economic factors. However, this can be a double-edged sword. Although it prevents your lender from increasing rates, it stops them from decreasing them. Lenders also offer higher interest for fixed-rate loans compared to those with variable interest.
Borrowers who prefer to secure a fixed-rate loan can help ensure they will qualify for one by having these in order:
- 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 that you don't have so much debt that you can't make a new payment. 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 Loans
Another type of personal loan is an adjustable-rate loan. You may also know them as variable-rate or float-rate loans. As you might have guessed, these directly contrast fixed-rate loans in how lenders compute interest rates.
Adjustable-rate loans work similarly to fixed-rate loans, except that your interest rates fluctuate over time. These may increase or decrease based on benchmark rates set by a bank, and the amount you pay each month may vary.
This type of loan may work if you only want a short-term loan. Although your rates may increase, they’re unlikely to surge within a few years. The potential change in monthly payments also makes budgeting more challenging. Adjustable-rate loans are best for borrowers who can repay the loan quickly.
Lenders also typically offer a lower initial rate for adjustable loans than fixed-rate loans. However, the latter are more widely available. Once you get the funds, though, you can generally use them for different types of purchases. Restrictions for usage tend to be lender-specific.
It's best to have the following things to qualify for an adjustable-rate loan:
- Credit history: Everything in your credit report is part of your credit history. It shows lenders how well you can manage various debts.
- Credit score: Tied to your credit history is your credit score. 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. Ideally, you should keep your debt-to-income ratio to 36% or lower.
Frequently Asked Questions About Personal Loan Types
If you're considering applying for a personal loan, it's best to understand the available types. MoneyGeek collected the most commonly asked questions about this subject to help you make the best financial decision based on your specific situation.
A significant advantage of getting a personal loan is that there are few restrictions on using your funds. Borrowers typically use them for home improvement programs, medical bills and significant purchases. However, you can also use one to fund a long-awaited vacation or consolidate your debt.
Maximum loan amounts vary between lenders. For example, American Express offers as much as $40,000, while Lightstream allows you to borrow up to $100,000. Sometimes factors about your financial health, such as your credit score and verifiable income, affect loan limits.
Some lenders charge an origination fee, which may put a dent in the amount you receive. You also need to watch out for prepayment fees, which could become a disadvantage if you have a chance to repay your loan earlier than planned.
Despite the different types of personal loans available, they’re not for everyone. Fortunately, they’re not the only answer to cash flow challenges. If for any reason a lender denies your application, you can consider using credit cards, dipping into your savings or emergency fund or borrowing from your loved ones.
A personal loan will impact your credit score, and its effect can go both ways. A personal loan can increase your credit mix, which makes up 10% of your credit score. Using a loan to pay off existing debt can help lower your credit utilization, which accounts for 30%.
How well you manage your repayments can also significantly affect your credit standing. Making payments in full and on time increases your payment history. Conversely, delayed or missed payments are likely to lower your credit score.
Besides a filled-out application, lenders typically ask you to submit several documents during the application process. These may include the following:
- Proof of identity, like your U.S. passport or driver's license
- Proof of income including pay stubs, income tax returns or bank statements (for self-employed borrowers)
- Proof of residency using utility bills and insurance documents
Yes, you can pay more than your monthly due. However, it's smart to check with your lender to find out if they charge a prepayment fee.
These days, personal loan applications can be as fast as a couple of hours up to as long as a week. Some lenders, like Lightstream, offer same-day funding. However, if you need to submit documents, the process will likely take longer.
sources
- Experian. "The Average Personal Loan Balance Rose 3.7% in 2021." Accessed July 2, 2022.
- Best Egg. "Personal Loan Application Requirements." Accessed July 2, 2022.
- Credit.org. "What’s a Good Debt-to-Income Ratio and How Do You Calculate It?." Accessed July 2, 2022.
- Federal Reserve. "Consumer Credit – G.19." Accessed July 2, 2022.
- Experian. "Personal Line of Credit vs. Credit Card: Which is Better?." Accessed July 4, 2022.
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.
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