Personal loans: What are they, and what to know before you apply for one

What is a personal loan? Glad you asked!

In the simplest possible terms, a personal loan is money someone (the borrower) receives from a bank or credit union (the lender). The borrower agrees to repay the lender over time with interest, which is a set amount extra each month on top of the initial amount of the loan (aka, the principal). There are many different kinds of personal loans out there, and many reasons you might want to apply for one, but that’s the basic idea.

Personal loans can often be the most cost- and time-efficient solution for someone looking to organize their finances. They can cover an unexpected expense, fund a spontaneous splurge, supplement day-to-day expenses when ends don’t meet, help out in an emergency, or give someone at the very beginning of their financial life a tool to build up their credit score.

Whether you’re a total beginner or you’ve been in the ring for a few rounds already, we’ve prepared this easy read about the different types of personal loans and their uses, the requirements for getting a personal loan, and the best way to go about taking out a personal loan in your area.

What even is a loan?

Let’s start at the beginning. There are three main factors to consider when thinking about retail lending, the broad category includes personal loans. (Retail lending is also sometimes called “consumer credit” — keep that in mind later!)

1. Loan term

You’ve heard that time is money, right? Well that’s kind of a fundamental lending concept. There are two basic types of loan term, which specify the loan repayment timeline: closed-ended, which means the loan must be repaid on a pre-determined schedule, and open-ended, meaning that the loan can be extended at will up to a certain dollar amount.

Closed-ended loans. Some people take out a loan so they can afford to buy a car. Auto loans are closed-ended: you have a set amount of time (say, 5 years), to pay off a specific amount of money. If you want to take out a personal loan to offset certain costs, like back-to-school expenses, this will also usually be a closed-ended loan paid off in set installments.

Open-ended loans. Now think about a credit card. You probably don’t see it this way, but that slim piece of plastic is a tiny loan machine. Every time you rack up a charge, online or off, you are technically taking out a loan in that exact amount and paying it back on your credit card’s monthly payment. That’s an open-ended loan, and credit card budgeting is just another form of debt management. Open-ended loans are also called revolving credit, to distinguish them from fixed-term loans, which are called installment credit.

2. Interest rate

The interest rate is probably a concept you have at least a basic awareness of. It tends to get more attention than the repayment timeline or term. The interest rate is the amount of money you pay on top of the amount you borrowed in the first place, aka the principal. There are two types of interest rate: fixed, which stays the same for each monthly payment; and variable, which can fluctuate. Variable loan rates are also called adjustable interest rates.

Pro tip: the interest rate on an open-ended loan (your credit card) is usually going to be way higher than what you’ll get on a personal loan with a set repayment schedule. That’s why consumer credit (also called consumer debt) is a multi-trillion-dollar industry: lots of money in small, short-term, high-interest loans!

3. Secured vs unsecured loans

The third major variable for a loan is whether it's secured by assets, like a car or a house, or not, meaning it’s unsecured. From a lender’s perspective, there’s less risk in giving out a loan for someone to buy a car, because in the worst-case scenario, they can recoup some value by taking that car if the borrower stops making payments. It’s a cold way to look at things, but it’s how lenders make money. That’s what makes it a secured loan.

An unsecured loan, on the other hand, is based on creditworthiness. That’s a five-syllable word that means your credit score. Before giving out an unsecured loan, a lender will take a close look at your credit history and will use it to figure out your interest rate. In most cases, excellent credit = low interest for an unsecured personal loan.

What are the different types of personal loans? Why are there so many?!

To bottom-line it for you: most personal loan amounts are lower than a typical auto loan or mortgage — in the thousands rather than tens of thousands of dollars. Personal loans are typically fixed rate, closed-ended loans with a clear repayment timeline. They are unsecured, and the interest rate depends greatly on credit score. Because they’re repaid via monthly payments, personal loans are sometimes referred to as installment loans.

Depending on how these factors all combine, there are lots of different loans serving different needs and niches. At one extreme is the payday loan. These loans are designed to attract people with low credit and hook them into long-term debt by offering fast cash at very high interest rates. Payday loans are also referred to sometimes as no-credit-check loans. Unless you have no alternative, they’re probably best avoided. Short loan term + high interest rate = worse deal for you. (Here are some other personal loan scams and traps to avoid.)

At the other end of the personal loan spectrum is the credit builder loan. This is like credit score training wheels. You take out a short-term (usually 6-24 months), fixed-rate loan and pay it back on time, thus bumping up your credit score.

Debt consolidation loans are another solution that many people are looking for. Maybe your credit isn’t as great as it could be because you’ve been overwhelmed by multiple bills for multiple credit cards. Much of the time, a personal loan to consolidate multiple sources of debt can save money in the long term, especially if you can find a local community bank or credit union to extend you a loan with a lower interest rate.

What are the requirements for getting a personal loan?

Your credit score is only one piece of information you need to gather before applying for a personal loan. What are the other requirements? What is the process like?

Let’s say you want to take out a $2,000 loan to cover the cost of a move. You figure you’ll be able to pay it off within a year. When you ask a lender (a bank or credit union) for this amount, the lender will want to know how much you can afford to borrow, from their perspective. To figure that out they’ll give you a loan application to fill out. (One early red flag to look out for: upfront and hidden fees!)

To verify you are who you say you are on that form, you’ll need to provide a valid ID. The more info you can give to the bank about your financial picture, the better, especially if you are able to get proof of employment, or proof of regular income. Proof of address can also give the lending officer a better sense of your overall stability. Since in this example you’re moving, this might be tricky to prove. So you should tell your bank what the loan is for up front.

And of course, they are going to take a good, long look at your credit score. This three-digit number gives them an instant idea of how good you’ve been at paying off your debt in the past.

The requirements for any given personal loan will depend on the loan amounts and loan terms, which will in turn affect the interest rate, which determines your monthly loan payment.

How to choose a lender for a personal loan

At Kasasa^® we believe in banking local. How can you ensure you are getting the best personal loan for your needs from lenders in your area?

A personal loan from a local bank or credit union can often be a better deal than a credit card, and more attuned to your specific needs than an online lender. Local, community-based financial institutions are more invested in the borrower than megabanks, and more likely to help you settle into a loan term and monthly payment that you feel comfortable with in the long run. If it’s a get-on-your-feet type small personal loan, or a debt consolidation loan to clean up your bills and create a foundation for building good credit, a local lender will be more likely to work with you to achieve your goal.

A less touchy-feely reason to promote local financial institutions over online or megabank loans is simple: they’re far less likely to charge you a fee for granting you a loan. Watch out for any loan that has an application fee, origination fee, or a loan that requests “collateral,” such as your personal bank information. These are at best lousy loans, and at worst a scam.

At the end of the day, you probably just want the best deal. Whether you have excellent credit or bad credit, a mountain of credit card debt or a lean financial portfolio, the best lender will be the financial institution that can best meet your needs. This can mean saving you time (with a shorter loan term) or saving you money (with a lower interest rate). Stay tuned for our next blog post, when we move past the “what” and dive deeper into the “where,” and explain why we think local, community financial institutions are the best bet for taking out a personal loan.

A Kasasa Loan^® will give you total control over the variables we just covered, and help you borrow smarter instead of racking up more high-interest debt when it can be avoided. Our unique Take-Back™ feature lets you reclaim extra money you’ve already paid toward your loan, giving you access to funds when you need them most. A Kasasa personal loan is the best place to start taking control of your debt!

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