Types of Personal Loans: Definitions and Uses

Personal loans offer you more flexibility in how you can use the funds. You can consolidate high-interest debt, make home improvements, cover unexpected medical expenses or fund a large purchase.

There are different types of personal loans tailored to specific purposes. Exploring each type will help you understand your options and choose the one that best suits your circumstances.

Secured personal loans require collateral to secure the funds borrowed. Collateral is a guarantee to lenders that you will repay your loan, reducing their risk in case you default. Common collaterals accepted include real estate, vehicles, insurance policies or savings accounts.

Secured personal loans are typically offered by banks, credit unions and online lenders. These loans often come with higher borrowing limits. They are more accessible if you have a lower credit score or don't qualify for unsecured loans. Note that the application process can be more rigorous, as lenders typically require a more thorough evaluation of your net worth.

If you fail to repay a secured personal loan, the lender could seize and sell the collateral to recover its losses.

Unsecured personal loans don’t require collateral to secure the loan. Instead, lenders use the borrower's creditworthiness and financial background when deciding whether or not to approve the loan. Determining factors include credit score, income stability, employment history and debt-to-income ratio.

With an unsecured personal loan, you avoid the risk of losing your asset if you default on the loan. The application process is also faster and simpler, making these loans a convenient option if you need quick funds. However, unsecured personal loans may have higher interest rates and lower borrowing limits. Missing payments can also have severe consequences, including damage to your credit score and potential legal action by the lender to recover outstanding debt.

You might consider a co-signed loan to access financing if you have a limited credit history or a low credit score. A co-signer is typically someone with a strong credit history and stable income, providing reassurance to the lender. They increase the likelihood of loan approval and potentially secure better loan terms for the primary borrower.

A co-signer on a loan application acts as a guarantor and agrees to repay the loan if you default. As such, you should carefully consider who your co-signer will be. This person should have good or excellent credit standing, a low debt-to-income ratio and enough earnings to pay your monthly due.

Note that defaulting on the loan can have severe consequences for both parties, including damage to credit scores and a strained relationship between you and your co-signer.

Debt consolidation loans exist to help individuals manage multiple debts more efficiently. These loans allow you to combine various high-interest debts, such as credit card balances, into a single, more manageable loan with a potentially lower interest rate.

Interest rates on debt consolidation loans are often lower than credit card interest rates. For example, the average interest rate for credit cards is 21.59% as of February 2024, while the average rate for personal loans is 12.49% based on Federal Reserve data.

In addition to simplifying finances and saving money on interest payments, debt consolidation loans can also improve your credit score by reducing your credit utilization ratio and demonstrating responsible debt management to creditors.

Personal lines of credit (PLOCs) are structured differently than traditional personal loans. Interest is only charged on the amount you borrow from the credit line, and you can continually access funds up to your predetermined credit limit as long as you make timely payments.

PLOCs are ideal for covering unexpected expenses, managing cash flow fluctuations or financing ongoing projects where the total cost is uncertain. You can withdraw funds as needed and repay them over time, making PLOCs a convenient option if you require periodic access to funds without committing to a lump-sum loan.

Note that you can face penalties for making late payments or exceeding your credit limit. PLOCs may also require collateral or a strong credit history to qualify, limiting their accessibility.

Fixed-rate loans are a type of personal loan where the interest rate remains constant throughout the loan term. This means your monthly payments remain the same, making budgeting easier and providing stability. These loans also protect you from interest rate fluctuations, as the rate remains constant regardless of changes in the market.

Although the fixed interest rate provides stability, it may be initially higher than variable rates. You may also face penalties for early repayment or refinancing, limiting flexibility.

Unlike fixed-rate loans, where the interest rate remains constant, adjustable-rate loans or variable-rate loans have interest rates that change based on market conditions. This means that there may be changes in your monthly payments as interest rates rise or fall. Personal loans don’t usually come with adjustable rates unless they’re auto loans.

Adjustable-rate loans offer flexibility and potentially lower initial interest rates than fixed-rate loans. These features make them attractive to borrowers seeking lower upfront costs or planning to refinance. However, fluctuating interest rates can lead to unpredictable monthly payments, making budgeting challenging. You may also face higher monthly payments if interest rates rise, increasing financial strain.

Not all personal loan options are created equal. Some types of personal loans come with high costs and added risks — it’s best to avoid them if you can. Here are a few to watch out for:

• Credit card advance: With a credit card advance, you can withdraw cash from your credit card. However, this option comes with very high interest rates and extra fees, often leading to a cycle of debt accumulation.

• Payday loan: Payday loans provide quick access to small amounts of money for various purposes, typically due on your next payday. Despite their convenience, payday loans have extremely high interest rates and short repayment periods. Borrowers often struggle to keep up with repayment demands, facing exorbitant fees and penalties that worsen their medium and long-term financial situation.

• Pawnshop loan: Pawnshop loans involve borrowing money by using valuable possessions as collateral, such as jewelry or electronics. However, you risk forfeiting your items for a fraction of their value if you can’t repay the loan.

• Title loan: With a title loan, you use your vehicle's title as collateral to secure a loan, typically at high interest rates. Title loans are a risky and costly borrowing option, and you risk losing your vehicle if you fail to repay the loan.

We answered some frequently asked questions about the types of personal loans available to help determine which one is the best option for you.