A personal loan is a type of consumer financial product whose purpose is to fund a major expense other than education or the purchase of an asset other than a home or vehicle.
Like all closed-end credit, personal loans have predefined durations and can be repaid via periodic installments, at any point until the final term, or in one-shot in the final term. The lender decides which repayment specification(s) it offers.
Personal loans are not the same as revolving credit, which refers to an agreement in which a lender makes available a sum of debt for use and repayment without an end date (i.e. a credit card).
Summary
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Personal loans fund large life expenses.
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Home loans and auto loans are not considered personal loans, despite being "personal" assets.
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There are 13 generally accepted uses for personal loans.
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Personal loans are structured as installment loans payable monthly, with only rare exceptions.
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Personal loans are unsecured, so borrowers pledge no collateral.
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Credit requirements are typically high.
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Loan servicers are usually efficient and friendly due to the high profit these loans provide, contrary to other loan types..
Purpose
The purpose of personal loans is to provide a lump sum of cash that borrowers can use to finance a major expense or asset—such as a wedding ceremony or kitchen appliance—for which they have insufficient cash to buy outright.
Popularity
Based on data from the Board of Governors of the Federal Reserve¹, personal loans represent approximately 11% of non-mortgage consumer loans in the United States. The remaining 89% belongs to education and auto loans.
"Personal" is Misleading
The use of the word "personal" is misleading because not all consumer loans are personal loans. For example, loans used to fund the purchase of a house (called mortgage loans), are not personal loans.
Additionally, loans used to purchase a car, mobile home, trailer, or other vehicle are not personal loans. Student loans, or education loans, also fall outside the scope of personal loans.
The term "personal" evolved as a default category for consumer loans issued for purposes other than education, auto, and home loans.
That said, personal loans cannot be used for any purpose. Lenders usually require the borrower specify how she/he will use the funds.
Use of Funds
Based on a sample of select online providers, lenders accept 13 specific expenses and assets as legitimate uses of personal loan proceeds. There is 1 use unrelated to expenses and assets: debt consolidation.
Assets
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Appliances. Examples include washing machines, dishwashers, and dryers.
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Water heater. Water heaters last many years, but they can be expensive to replace.
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Mattress. Mattresses are large purchases that can last 15 years.
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Furniture. Examples include tables, couches, and TV racks.
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Engagement rings. Engagement rings, while usually unsold, hold value over time.
Expenses
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Vacation. Vacations can be expensive and do not hold value.
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Moving expenses. Examples include plane tickets, moving trucks, moving companies, shipping costs.
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Medical bills. Bills not covered by insurance or copay obligations.
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Dental work. Bills not covered by insurance or copay obligations.
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Veterinary bills. Expenses related to taking care of furry friends.
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Wedding & honeymoons. An expense that serves as a lifetime memory but does not hold commercial value.
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Funeral expenses. The costs associated with the ceremony and burial services.
Hybrid
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Home improvements. Home improvements can be considered both an expense and an asset. They're an asset insofar as they increase the value of a home but an expense if the owner never sells.
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Pool installation. Pool loans are like home improvement loans. They can be an asset when they increase the value of the home but an expense when a sale never occurs.
Debt Consolidation
The last kind of personal loan is debt consolidation. These loans streamline 2 or more other loans or revolving lines of credit (such as credit cards) into a single payment structure.
The primary value of consolidation loans is simplifying payments to avoid errors, but they can also reduce the overall cost of debt when the new interest rate is lower than the sum of past rates.
Structure
As a type of closed-end credit loan, personal loans have 6 of 8 properties, shown below. They do not include collateral or grace periods like other loans.
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Principal amount. The amount of money provided to the borrower for the expense or asset purchase.
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Term. The term is the duration of the loan, usually measured in months.
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Payment terms. Payment terms specify how frequently the borrower must pay down the loan. They can be periodic, discretionary, or one-shot. Periodic is the most common and colloquially called "installments," usually paid monthly. Discretionary means the borrower is free to make payments at any time before the end of the loan. One-shot, or "bullet payments," are single transactions to reimburse the total value of the principal + interest before the end of the loan term.
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Interest Rate. Interest rate is a percent applied periodically on the outstanding balance of the personal loan. In most cases, it applies monthly. Interest rates are almost always yearly rates, which means the monthly rate is the annual rate divided by 12.
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Annual Percentage Rate (APR). Like interest, APR is a percent. However, interest rate and APR are not the same. APR is a percent representation of the total interest paid as relative to the principal balance if it were paid over a 365 day period.
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Fees. Fees are administrative costs lenders charge to process the personal loan. The most common type is an origination fee. Origination fees are usually 5% of the principal amount and are deducted from the loan proceeds at the start of the loan. Learn more here.
Personal Loans are Unsecured
Personal loans are unsecured by definition. This means the borrower does not pledge an asset or cash that the lender can confiscate in the event of loan default. Because personal loans do not have collateral, they usually have higher interest rates than other loans to compensate the lender for taking more risk.
However, there are two exceptions.
Exceptions: Credit-Builders & Savings-Secured Loans
Credit builder loans (CBLs) and related savings-secured loans (SSLs) are personal loans that use collateral, and are therefore secured.
The inclusion of CBLs and SSL as personal loans is unofficial but a practical reality given the large volume of lenders including these loans as products under the personal loan branch of their lending activities.
The growing popularity of CBLs and SSLs as tools to obtain more favorable terms on auto, mortgage, and other personal loans makes them potential candidates for a new category of consumer loans.
Credit Requirements
With the exception of CBLs and SSLs, personal loans typically require good credit profiles. This doesn't mean borrowers with average credit are automatically denied, but they will end up with high interest rates.
Borrowers with thick credit profiles project a sense of reliability that personal loan lenders reward with quick approval and low rates. It's a privilege anyone can earn by carefully constructing a meaty profile.
Speed
Personal loans are reputed for distributing funds quickly. Online lenders in particular have developed automated approval processes and can distribute funds within 24 hours, and sometimes on the same day.
Auto-pay
Most personal loan lenders provide an auto-pay feature within their interface (app or website). Auto-pay is a must-have because it prevents penalties and damage to credit as a result of simply forgetting to pay.
That said, auto-pay only works when the borrower has sufficient funds to make the payment.
Parties Involved
Like all closed-end credit, personal loans are agreements between at least 1 lender and 1 borrower.
Lender
The lender is the party that extends the principal amount. Personal loan agreements almost always have a single lender because the principal amount is not high enough to require teamwork. We know of zero personal loans provided by more than 1 lender.
Borrower
The borrower is the party that receives the principal amount and carries the obligation to reimburse before the end of the loan term. It is possible for 2 or more borrowers to take out a personal loan together, but it's less common than co-borrowing for mortgages.
A primary borrower with poor credit can solicit a co-signer to obtain approval and better rates. The co-signer is a guarantor that agrees to pay the loan in the case the primary borrower defaults. Co-signers do not, however, obtain rights to the asset or expense funded by the loan.
Due to the imbalance in cost and benefit, unrelated co-signers are rare. The most common example of co-signing on personal loans is a close family member who wants to lend a helping hand.
Markets
Personal loans are available in every modern economy. They are particularly present in Anglo-Saxon countries such as Australia, the United States, the UK, and Canada.
However, there is a fine line between personal loans and predatory title or payday loans. The latter are illegal in many countries and some U.S. states, such as Georgia and Pennsylvania.
Renegotiation
Renegotiation of personal loan terms during the term of the loan is possible with some lenders. Borrowers may ask to decrease the interest rate, for example, is national rates are lower. Lenders have an incentive to renegotiate because they can otherwise be paid off if the borrower seeks a debt consolidation loan with another lender.
Citations
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“Federal Reserve’s Consumer Credit Dataset.” n.d. Thickcredit.com. https://thickcredit.com/datasets/public-federal-reserve-consumer-credit-dataset.
