How Does a Personal Loan Work?

No Collateral

The term "personal loan" can refer to two different types of loans. Financial institutions use this term to describe a loan that is not secured by any form of collateral. It is also called a "signature loan" because the only thing securing the loan is the borrower's signature. A loan is also considered a personal loan when it is between two people as opposed to one person and a financial institution as the lender. Either way, the loan is for an amount of money that needs to be paid back, plus any interest and fees that were agreed upon in the original contract. Even personal loans between friends and family members should have documentation spelling out the terms of the loan, otherwise it becomes difficult to prove the terms of the loan if needed.

Payments Are Made

The original contract for the personal loan sets the payback schedule as well as details the fees and interest rate. The borrower pays the lender a set amount of money on a recurring basis. The most common payment schedule is a monthly payment that pays for both the principal balance as well as interest charges. If the payments are made as scheduled, and no additional payments are made, the loan will be paid off according to the original amortization. Common amortizations for personal loans are 24, 36 and 48 months, although it depends largely on the amount of money originally borrowed and the ability of the borrower to make monthly payments.

The Loan Is Paid Off

If the borrower defaults on the loan then it's a tricky situation for the lender because there is no collateral attached to the loan. The lender can demand payment and sue the borrower, but bankruptcy can usually discharge this debt relatively easily. Some lenders charge prepayment penalties, so a borrower paying off a personal loan early might wind up with extra fees. Without a prepayment penalty the borrower winds up paying less if the loan is paid off early because less interest is charged overall. If the borrower pays everything as scheduled then the loan is considered paid in full when it reaches a zero balance and there are no further fees or interest charges.

Resources

• How to Get a Personal Loan Fast