Personal loan: the path from application to the final payoff

A personal loan pays you a lump sum up front, which you repay in equal monthly installments over a fixed term, usually two to seven years, at a rate set mostly by your credit. The path runs from prequalifying with soft credit checks, to one formal application, to a federal disclosure you should read line by line, to funding within days, and then to an amortization schedule that sends a little more of each payment to principal every month.

Before you apply: what lenders weigh

Lenders look at three things: your credit reports and scores, your income, and how much of that income already goes to debt payments, your debt-to-income ratio. There is no federal DTI limit for personal loans; each lender sets its own.

Many lenders let you prequalify with a soft inquiry, which shows you an estimated rate without affecting your score. The formal application usually triggers a hard inquiry. Prequalifying with several lenders first, then applying to the one or two with the best estimates, keeps the hard pulls to a minimum; how much an inquiry actually costs is covered in what a hard inquiry really costs. Don’t count on several personal loan applications being treated as one inquiry, as mortgage and auto shopping can be.

Reading the offer

Before you sign, the Truth in Lending Act requires the lender to give you a standard disclosure with four numbers:

• Amount financed: the credit you actually receive. If there is an origination fee taken out of the loan, this figure is lower than the loan amount.
• Finance charge: the dollar cost of the credit, including interest and fees such as an origination fee.
• Annual percentage rate: that cost expressed as a yearly rate.
• Total of payments: everything you will pay if you make every payment on schedule.

The disclosure also has to say whether you would pay a penalty for paying the loan off early. As an example, on a $10,000 loan over 60 months at an APR of 10%, the total of payments is $12,748.23 and the finance charge is $2,748.23.

When you compare offers for the same amount and term, the lower APR is the cheaper loan. Across different terms, or when one offer has a large upfront fee and you might pay early, run the comparison in APR vs. interest rate, which shows where a fee loan stops being the better deal. For a sense of current pricing, this is the Federal Reserve’s average APR on a 24-month personal loan at commercial banks:

How each payment is split

After you sign, most lenders deposit the money directly into your bank account, sometimes as soon as the next business day, and the first payment is typically due about a month later. Setting up automatic payments right away protects you from a missed payment, which brings a late fee and, once 30 days late, a mark on your credit reports.

Each payment covers that month’s interest on the remaining balance, and the rest reduces principal. Here is the $10,000, 60-month example at an APR of 10%, with a fixed payment of $212.47:

Because interest is charged only on what you still owe, extra principal pays off quickly. Adding $100 a month to the same loan, marked as a principal payment, clears it in 38 months instead of 60 and saves $1,068.53 in interest. Check the prepayment line on your disclosure first, and confirm with the lender that extra money goes to principal rather than to the next payment due.

After the last payment

When the balance reaches zero, the lender reports the account as paid and closed. A closed account in good standing generally stays on your reports for up to 10 years and keeps counting toward your payment history and the age of your credit.

Some people see a small score dip right after the payoff. It comes mainly from no longer having an open installment loan being paid down, not from losing the account’s history. The effect is usually modest and temporary, and the payment you no longer owe matters more. The details are in why your score can drop after paying off a loan.

When a personal loan is the wrong tool

The most common legitimate use is consolidating card debt at a lower rate. It saves money only if the loan’s APR, including any fee, is clearly below what the cards charge, and only if the cards do not fill back up. Stretching the term to cut the monthly payment can erase the saving. The calculator below compares the two at the same payoff window:

A personal loan is a poor fit in three other situations. If your income is unstable, the fixed payment does not shrink when your paycheck does, and default leads to collections and possibly a lawsuit. If the expense can wait, saving for it costs nothing. And if your credit is weak, the rates offered can be high enough that other options cost less; those are compared in personal loans with bad credit.