Personal Loans Primer: What they are, features, and when they make sense

Spring is a perfect time to clean up your finances, including building an awareness of the kinds of debt you may have. In this post, we're talking personal loans - what they are, how they work, and my thoughts on common use cases.

What they are:

• A personal loan is a lump sum deposited to your bank account upon approval

• You pay it back with a fixed monthly payment that stays the same for the life of the loan

• Most are unsecured, meaning they are not backed by collateral. If you can’t repay your loan, the lender is not entitled to any assets you own, like they would be with a mortgage on a house.

How they work:

• You’ll pay back more than you borrowed due to interest, which is calculated using the APR (Annual Percentage Rate) on your loan

  • The APR on your loan depends on factors such as your credit score, income, and existing debts

  • The average APR for a personal loan is currently 11%, up from 8.75% in May of 2022

  • A co-signer can help qualify you for a loan or lower the interest rate, if they’re willing to assume responsibility for your debt

• Some personal loans have an origination fee of 1%-10% of the loan amount. This may be subtracted from the lump sum you receive, or added to the amount you have to pay back

  • Example: a $10,000 loan with a 2% origination fee. If subtracted from the lump sum, you would receive $9,800. If added to your balance, you would pay back $10,200 plus interest

• On-time payments can improve your credit score, and late or missed payments will lower it

  • If you have trouble keeping up with your monthly payment, call your lender sooner rather than later. They will likely work with you to postpone or reduce your payments so you can keep the loan current

Use cases:

• Buy Now, Pay Later (BNPL) - a type of installment loan offered at checkout that splits the cost of a purchase into four or more equal payments

  • APR on these plans can range from 0% for “pay-in-four” up to 36% for monthly plans, and late fees can be steep

  • My experience: when you’re deciding whether to buy something that’s borderline-affordable, BNPL can muddy the waters. If you can make the first payment, the purchase can feel reasonable – and then you’re charged the same amount three more times. Several of my clients have found that recurring charges for past purchases have slowed progress on their goals.

• Emergencies - if you’re early in the process of building your emergency fund, a personal loan is usually a better option than putting unexpected expenses on a credit card, given the lower APR

  • The average APR for a credit card is 21%, ten points higher than the average for a personal loan

• Debt consolidation - juggling multiple payments with different dates and interest rates can be challenging. Personal loans also have lower interest rates than most credit cards, so if a consolidation loan lowers your average APR and simplifies your payment schedule, it’s a win-win 

  • Borrow as close to the total of your existing debts as possible, so you’re not inadvertently adding to the amount you owe while working to pay it off

• One-time expenses - personal loans can help cover exciting-but-costly events like a wedding or dream vacation. My goal is for you to live your best life, and if that means a personal loan to pay for the good catering, go for it – just confirm that the payment fits your budget before you sign.

I hope you found this primer useful, and thanks for reading! If you'd like more content like this, sign up for my newsletter here so you never miss an update.