A loan is a sum of money that is borrowed and then paid back, both principal and interest, within a specific time frame. The interest you pay is for the privilege of getting that lump sum of cash in hand.
Whether it’s to continue your education or buy a house, borrowing money can be the key to meeting longer-term goals, both financial and personal. There are many different kinds of loans available, including unsecured personal loans, secured mortgages, and many other options in between.
Here, you’ll learn the basics of lending, including a few of the most common types of loans, what you’ll need to successfully apply for them, and what you should know before making the significant and at times risky decision to borrow money.
Definition and Basic Concepts
As soon as you start shopping for loans of any kind, there are a few terms you’re likely to hear, some of which may be unfamiliar. Get up to speed with this glossary of words commonly used to define and describe loans.
• The principal is the amount of money you’re borrowing from the lender. For instance, if you take out a loan for $17,500, then the principal amount is $17,500. However, every time you make a payment, you’ll pay both principal and interest, which is why you’ll end up paying back more than $17,500 altogether. (It may also be possible to make additional, principal-only payments, which can help you pay the loan off more quickly and pay less interest overall.)
It’s worth noting that this concept of principal is a key way that loans vary from credit lines: With a loan, you typically get a lump sum of cash, while with a line of credit (such as a home equity line of credit, or HELOC, or a credit card), you borrow varying amounts as you need funds.
• Interest is the money you pay to the lender for the privilege of taking out the loan — or the cost of the loan. Interest is often expressed as an annual percentage rate (APR), which includes any additional fees as well as the interest itself.
• A loan’s term is the lifespan of the loan, or the length of time you’ll have to pay it back. For example, a personal loan might have a 60-month (five-year) term, meaning you’ll make 60 monthly payments to repay the loan in full (unless you pay it off early). Mortgages tend to have longer terms: typically 15 or 30 years.
• Collateral refers to an asset that, as part of the loan agreement, the lender can seize in the event you fail to repay what you owe. A loan with collateral is known as a secured loan, and common collateral items include vehicles (as with an auto loan) and houses (as with a mortgage).
• Your lender might be a bank, credit union, or an online financial institution. It’s whichever business is lending you the money and collecting your payments.
• The borrower is the person or entity borrowing money and paying it back as outlined in the loan agreement.
Types of Loans
While there are many different kinds of loans out there — home loans, auto loans, personal loans, and even holiday loans — they can all be separated into two main categories: secured loans and unsecured loans.
Secured Loans
As briefly mentioned above, secured loans are those that are backed by collateral.
Collateral gives the lending institution a guarantee that they’ll get a valuable asset out of the deal if the borrower fails to repay the loan in full. That means the loan is less risky for the lender, which may have slightly less stringent qualification requirements or might charge a lower interest rate.
Unsecured Loans
Unsecured loans, by contrast, are those that are not backed by collateral. Unsecured loans, like personal loans, are sometimes also called “signature loans,” since all you’re offering as collateral is your signed promise to repay the loan. Because they’re riskier for lenders, unsecured loans may have higher interest rates as well as more stringent eligibility requirements.
Unsecured loans can usually be used for just about any legal purpose, from home renovations to wedding costs. Many people take out personal loans for debt consolidation; say, as a path to paying off high-interest credit card debt.
Common Loan Terms
While the specific agreement of your loan will depend on multiple factors, including your lender and the type of loan you’re taking out, there are a few features that many different types of loans share.
APR
Your interest rate will likely be expressed as an APR percentage. APR includes not only the interest itself but also the other costs associated with the loan, such as origination fees.
APRs can vary tremendously depending on an array of factors, including the economy, the size of the loan, the type of loan, your credit score and history, and more. At the low end, some people who took out a mortgage in late 2020 or in 2021 may have an APR below 3.00%. Others who have less-than-stellar credit scores might currently have an APR of 30.00% if they are seeking out a personal loan on the larger, riskier side.
The higher your APR, the higher the cost of the loan. People with higher credit scores and positive financial profiles are more likely to qualify for lower-APR loans, which can save them substantial amounts of money in interest over time.
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Fixed vs Variable Interest Rates
Along with APR, you should also understand the difference between fixed and variable interest rates.
• As the name implies, fixed interest rates don’t vary over the entire lifetime of the loan. That means you can enjoy regular, predictable payments in the same amount every month.
• Variable-rate loans, on the other hand, can fluctuate with the market (though are usually governed by caps that keep the rate from rising over a certain percentage). Variable-rate loans may have lower rates at first, making them attractive, but payments can rise substantially over the lifetime of the loan. Or in some economic climates, they might fall lower. In either scenario, a variable rate can make budgeting more difficult.
Amortization
Amortization describes the way a loan is gradually paid off (both principal and interest) over time. Payments are typically made over a particular schedule, such as monthly for a certain number of years.
For example, with a fixed-rate home loan, you’ll typically find that the mortgage amortization occurs so that, toward the beginning, the bulk of your payment is going toward interest rather than principal. (This helps ensure the bank gets paid for their service up front.) Over time, a greater and greater percentage of the payment will go toward principal. However, the actual amount you’re paying each month will never change.
You can see the effect of amortization for yourself using a mortgage calculator.
Prepayment Penalties
Prepayment penalties refer to costs the lender might charge if you pay off a large portion of your loan early or repay the entire loan before the term has elapsed. Prepayment penalties help lenders make money on loans where they won’t receive the full term’s worth of interest. Prepayment penalties can help compensate the bank for this loss of interest income.
For borrowers, though, these charges can feel like punishment for what is generally a positive financial behavior: paying off your debt early. Whenever possible, it can be wise to look for loans that don’t charge prepayment penalties.
Loan Process
So, now that you understand a bit more about how loans work, consider how you go about getting one.
While each lender will have their own specific procedures and policies, the basic loan process can be broken down into four basic steps.
• Application. The lender will collect information from you about your employment history, income, and other financial factors, as well as verify your identity. These days, loan applications can usually be filled out online, though you may also be able to apply in person or over the phone.
• Approval. Once your lender verifies all your information — usually including a hard credit check — they will either approve or deny your application. If you’ve been approved, you’ll be informed about the approval, though it still may take some time for the money to come through.
Timing on these steps can vary greatly; a personal loan might get same-day approval, while a home equity loan, which typically involves a home appraisal, could take weeks.
• Disbursement refers to the money you’ve borrowed actually hitting your account. You may be able to set up direct deposit so the funds can find their way into your bank account without any additional steps, but in other cases the lender might cut you a physical check. With a home loan, a closing with various parties and/or their lawyers present might be required.
• Repayment is the phase of the loan where you pay back the funds borrowed (the principal) and interest and fees over time. This typically reflects the agreement drawn up when your application was approved. As discussed above, the repayment period, or term, could be as short as a year or two or as long as several decades.
Factors Affecting Loan Approval
Applying for a loan doesn’t guarantee you’ll be approved. After all, before transferring a large sum of money, your lender is going to want to feel confident that you can repay the debt.
Some of the most important factors that affect loan approval are your credit score and credit history, income, debt-to-income ratio (DTI), and the value of any collateral you put on the table. Here’s a closer look.
• Your credit score is the three-digit number (typically between 300 and 850) that summarizes your credit history and how well you have repaid debts in the past. You may actually have multiple credit scores due to different scoring models and the fact that each of the three major credit bureaus may report somewhat different information. Credit score monitoring can help you understand the health of your credit file over time.
• Your income is the amount of money you have coming in, usually from employment (but also potentially from investment interest or other sources). Lenders generally want to see a reliable flow of income to help ensure borrowers will be able to continue making payments over the entire lifetime of the loan.
• Your debt-to-income ratio or DTI is an expression of the amount of income you have every month compared to the amount of money that’s already promised to other creditors. Depending on the loan and the lender, you may be able to qualify for certain loans with a DTI of up to 50%, but generally, the lower, the better. Some mortgage lenders won’t offer a mortgage to borrowers with a DTI higher than 36%, for instance.
• For secured loans, the value of your collateral, such as the car or home you’re financing, is also considered as part of the calculus. A high-value asset or collateral makes the deal substantially less risky for banks, since they’ll still get some value out of the loan even if you don’t repay it.
Pros and Cons of Borrowing
Sometimes, borrowing money really can be a smart financial move, but it almost always comes with costs, so it’s important to think through the decision carefully. Here are some of the basic pros and cons of borrowing money.
Pros:
• Loans can help you access longer-term goals, like homeownership or college education, that might not be possible if you had to pay out of pocket.
• In some cases, debt in the short term can help you increase your financial standing in the long term. For example, student loans can help you gain skills that increase your earnings; mortgages can allow you to own an asset that can appreciate over time; and personal loans used for loan consolidation could help you improve your overall financial standing faster.
• With unsecured personal loans, you can use funds for just about any purpose — making them flexible and convenient.
• Some loans are quick and convenient; certain types can send money your way in just days.
• Making on-time payments can help build your credit score over time.
Cons:
• In almost all cases, loans cost money. High interest rates can mean purchases could cost far more than they would in cash over time.
• If you fall behind on payments or carry large balances of revolving debt, loans could have a negative impact on your credit score.
• Loans payments can stretch your budget, making it difficult to make ends meet each month and accomplish other financial goals, such as saving for retirement.
• Certain kinds of loan applications can be time-consuming and can leave you waiting a long while to learn whether or not you are approved.
• If you have a secured loan, you risk losing your collateral if you cannot keep up with your payments.
• If you have a lower credit score, borrowing money can be more expensive, which can make your loan debt burdensome.
Alternatives to Traditional Loans
While traditional loans from a bank have long been available to borrowers, there are alternative resources worth considering if you need cash.
• Credit cards are a common way for people to pay for things today with money they hope to have tomorrow. However, it’s wise to avoid using a credit card to buy more than you can afford to pay off before the grace period ends. Credit cards tend to have high interest rates (and higher still if you take a cash advance), and compounding can get out of hand fast.
• Lines of credit may be available, such as a personal line of credit or a HELOC, allowing you to borrow funds up to a limit, with interest accruing.
• Cash advance apps can help you access money from your next paycheck early, though the amount available tends to be relatively small.
• Peer-to-peer (P2P) lending platforms are an alternative way to borrow that’s funded primarily by private investors. Some people who’ve been turned down for traditional loans may still qualify for P2P loans.
• Family loans can work in some instances — depending, of course, on your family finances and dynamics. To avoid putting strain on a relationship, it’s often a good idea to formally write up a loan agreement including any required interest, the expected loan term, and what happens if the borrower defaults.
• Buy now, pay later options can allow you to purchase an item and pay it off in installments, sometimes interest-free. This could be a way to snag, say, a new kitchen appliance when you don’t have cash in hand.
• Payday loans allow you to borrow against your next paycheck, but proceed with extreme caution. The APRs on these can add up to 400% in some cases.
The Takeaway
A loan involves accessing a sum of money that you repay over time with interest to the lender, according to the terms of your agreement. Borrowing money can help you achieve your dreams, such as owning your own home or getting a graduate degree — but it usually comes at a cost, so it’s always worth proceeding with caution before signing on the dotted line. Understanding the full cost of the loan and its pros and cons will help you make an informed decision.
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FAQ
How does interest on a loan work?
Interest is the price you pay for the privilege of borrowing money. With most loans, interest is expressed as an APR, or annual percentage rate, which includes not only the interest rate itself but also any additional costs to the loan, like origination fees.
What’s the difference between a loan and a line of credit?
With a loan, you usually receive a lump sum of money up front which you then repay over the course of months or years. With a line of credit, instead of a lump sum, you receive a credit limit — the maximum amount you can borrow based on your financial credentials. From that amount, you borrow what you need up to your limit, and you can repay the line of credit and borrow again.
How do I choose the right type of loan for my needs?
The first step to choosing the right loan for your needs is to understand that there is a huge array of financial products available. What are loans can vary tremendously. For example, if you need money to buy a vehicle, a secured auto loan may have lower interest rates than a personal loan. If you need funds for a wedding, a personal loan may be the right option. It’s also worthwhile to shop around with different lenders once you know the type of loan you want. That can help you find the best possible loan terms, including the lowest interest rate.
Are there tax implications for taking out a loan?
There may be tax implications. The interest you pay on a mortgage is usually tax-deductible. In the case of personal loans, since they have to be repaid, they’re not considered income, so you won’t have to pay taxes on the disbursement. If the loan is forgiven, though, the cancellation of the debt may be considered its own form of income and may be subject to taxation on that basis. You may want to check in with a tax professional regarding your particular situation.
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