A personal loan can be a versatile, flexible way to finance a large expense or consolidate your debt. But taking out a loan can be costly, and it's essential that you know your way around a personal loan agreement—navigating APR, interest, amortization schedules and various fees with ease—to ensure that you make the best borrowing decision for you. Here are 15 important personal loan terms you should know before you apply.
Annual Percentage Rate (APR)
APR is the annual cost a borrower pays to take out a personal loan. APR on a personal loan bundles the loan's interest rate and any fees into one number, expressed as a percentage rate, to give a complete picture of the loan's yearly cost to the borrower.
If a personal loan doesn't have any fees, then the interest rate and APR are the same. When comparing two loans with different interest rates and fees, look to APR for an apples-to-apples view of which is cheaper.
Also called the applicant, the borrower is the person who is applying for a loan. When you're the borrower of a personal loan, you're responsible for paying back the loan according to the loan agreement you sign when you apply.
A lender may ask you to add a cosigner to your application if your credit score or income don't qualify you on your own. Adding a cosigner can also mean getting a better rate. Cosigners are often a borrower's close family member or friend with good credit and a stable income.
Your credit score is a three-digit number that represents your credit history. Lenders use your credit score, along with other factors such as your income, to determine your creditworthiness or risk as a borrower. A low credit score means you present more risk as a borrower, and this can make it challenging to qualify for a personal loan, or one with a low interest rate. A high credit score can help qualify you for the best rates and terms on a personal loan.
Debt consolidation is when you combine multiple debts, such as two or more credit cards, into one loan with a single monthly payment. While lenders may refer to a loan as a "debt consolidation loan," it is essentially a personal loan. By bundling multiple balances together into one loan, you can simplify managing your debt. In addition, a personal loan may offer you a lower APR than your credit cards, which can help you save money on interest.
Fixed vs. Variable Interest
Fixed-rate personal loans have an interest rate that doesn't change: The interest rate you see when you apply is what you'll pay for the life of the loan. This makes budgeting for monthly debt payments straightforward.
Most personal loans have fixed interest rates, but there are also variable rate personal loans, with rates that fluctuate according to prevailing national interest rates.
Hard vs. Soft Inquiry
Lenders use both hard and soft inquiries (also called hard and soft credit checks) to determine your creditworthiness.
When it comes to personal loans, a soft inquiry happens when a lender checks your credit report to prequalify you for a loan. It doesn't impact your credit score.
The lender will check your credit with a hard inquiry when you formally apply for a personal loan or another credit product. Hard inquiries appear on your credit report for up to two years and can cause a minor dip in your credit score for a few months. While this shouldn't deter you from applying for credit, it's a good reason to only apply for a personal loan when you really need it.
Interest is what a lender charges a borrower in exchange for lending them money. A personal loan's interest rate is typically expressed as a percentage. Along with any lender fees, interest makes up a personal loan's APR.
Throughout the life of a loan, you'll continue incurring interest on the remaining principal each month, and your monthly payments will go first toward paying down any outstanding interest and then toward lowering your principal.
Amortization is the process of paying down a personal loan with fixed payments. Your loan's amortization schedule describes how much you'll pay each month, when you'll make the payment and how that payment will be divided up between paying off accrued interest and your principal balance.
Loan Origination Fee
An origination fee is a one-time upfront cost charged by the lender to cover administrative expenses related to the loan. Origination fees are usually charged as a percentage of the loan and range between 1% and 8%.
For example, a $15,000 personal loan with a 5% origination fee would subtract $750 from the loan, leaving you with $14,250 deposited in your bank account.
A prepayment penalty or an early payoff fee is a charge for paying off your loan early. Prepayment penalties help lenders recoup some of the money they lose in interest when you pay off your loan early. Not all lenders charge them, so it's a good idea to shop around for a loan without an early payoff fee if you hope to pay off a personal loan early.
Prequalification is an indication from a lender that a borrower may qualify for a loan. To prequalify you, a lender reviews your financial details, such as your income and housing payments, and runs a soft credit check to determine whether you're likely to qualify for a loan. Prequalification doesn't guarantee you approval, but it's a good way to weed out lenders who aren't a match before deciding which loans to apply for.
Principal is the amount of money you borrow from a lender. Over the life of a loan, you make monthly payments toward the principal to reduce what you owe. However, since most loans also accrue interest each month, only part of the payment goes toward paying down the principal. Paying down your principal sooner can help you save money on interest.
Secured Loan vs. Unsecured Loan
A secured loan is a loan that has collateral attached to it so that if the borrower defaults on the loan, the lender can take possession of the asset. For example, some loans require you to pledge your home or car as collateral.
Most personal loans are unsecured loans, meaning you don't have to pledge an asset as collateral to qualify. Some lenders do offer secured personal loans, however, and borrowers with low credit scores may be able to access better loan terms by searching for a secured personal loan.
A loan's term is the number of months you'll have to repay it. Personal loan terms generally range from 12 months to 60 months.
While choosing a longer loan term will mean lower monthly payments, it also generally means your loan will be more expensive. The longer your term, the more months interest will accrue. On top of that, lenders typically charge higher interest rates for longer loan terms.
A shorter-term loan will be less expensive overall, but you'll need to be able to afford higher monthly payments.
When Are Personal Loans a Good Idea?
Personal loans can be used to finance just about anything, and if you have a high credit score, you may have access to loans with low rates. But taking on debt is always a big decision, and personal loans can be expensive—interest rates ranged from about 4% to 36% in April 2022.
Here are some common reasons to take out a personal loan:
- Consolidate debt. Consolidating multiple high-interest debts into one lower-interest debt consolidation loan can help you save money on interest while streamlining your debt management. If you qualify, consider using a balance transfer card as an alternative.
- Cover an emergency expense. A personal loan may help you afford a necessary expense now, such as a household or auto repair, and then pay for the expense (plus interest) in set monthly installments.
- Pay medical bills. While it's generally best to ask your medical provider about financing first, a personal loan can help cover urgent medical treatments.
- Fund a home renovation. You can use a personal loan to pay for a home renovation that will add equity to your home, such as a kitchen remodel or a deck replacement. Keep in mind that a home equity loan will typically offer you a lower rate because your home serves as collateral.
Your Credit Score Impacts Your Rates
A personal loan can be a good financing option, but only if you qualify for a low interest rate and favorable terms. Lenders typically extend the best personal loan offers to applicants with high credit scores.
Check your credit score for free through Experian for a big picture look at your credit. You can explore your credit summary to learn how lenders may see you and review a breakdown of the biggest factors impacting your score.