What Are Loans, and How Do They Work?

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Need to make a big purchase but don’t have the liquid cash to cover the entire cost? Whether you’re paying for a car, a new home, school tuition or something else, a loan helps you get the extra money you need while allowing you to pay it back over time. But different loans exist for different purposes and have different provisions, so it might not always be clear which type you need. 

While borrowing any amount of money can be intimidating, when done correctly, it can help boost your overall financial health and even your net worth over time. But it’s important to start at the beginning. To help you navigate the world of lending, we’re breaking down some loan basics. From the different types of loans to how a lender determines the interest rate you pay, think of this as your go-to guide to the fundamentals of lending.

Loan Basics: What They Are and How They Work

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A loan is an amount of money you borrow from a bank, financial institution, online lender or even a person such as a family member. Over time you pay this money back, usually with interest — extra money you give to the lender on top of the original loan amount for the privilege of borrowing the money. While there’s a wide variety of loans, almost all have similar attributes.

Almost all loans, for example, have a due date by which you need to pay them back; this is called the loan’s term. All loans then have payments you need to make on a set schedule or in a lump sum; this is how you repay the lender. People take out loans to pay for college, cars, homes, medical procedures and even to fund businesses.

How Do You Pay for a Loan? Interest, Terms and Payments Explained

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Before applying for a loan of any kind, you’ll want to know exactly how you’re paying for the loan. This is where your payment terms, interest rate and due date come into play. To start, you’ll always need to pay back the principal of the loan. This is the amount of money you originally borrowed. As a teenager, let’s say you borrowed money from your grandma to buy your first car. She may loan you $2,000 interest-free because she’s your grandma. In this case, you only owe her the $2,000 you borrowed. You also may want to throw in a few extra Sunday dinners in this scenario.

However, when it comes to borrowing from financial institutions, unless you have a 0% interest rate you usually can’t pay back loans without paying some form of interest after a certain point. Interest is the added cost of the loan, and it refers to the amount you’re paying on top of the principal. Interest rates can vary significantly. The interest rate a lender offers you depends on the type of loan you’re getting, your credit score, your credit history and the loan’s specific conditions.

Loans may have terms ranging in length from a few months to a few decades. A mortgage loan, for example, is often for a 15- or 30- year term. An auto loan is typically shorter, ranging from three to seven years. The term refers to the length of time you have to pay back the loan in full, meaning both the principal and interest. You’ll most likely do this by making installment payments, which means you’re making a set payment each month. A student loan or mortgage payment, for example, typically won’t change in amount from month to month and will be due on the same date each month. This differs from credit cards, which are another type of lending that may have different payment amounts each month depending on the amount you’ve spent on your card.

The Different Types of Loans

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While there are several different types of loans, most fall into two categories: secured and unsecured loans. An example of a secured loan is a mortgage or a car loan. These loans are secured because they’re backed by collateral — an asset you agree to give the lender if you’re unable to pay back the loan. In the case of a car loan, the car itself serves as collateral. The lender can repossess the vehicle if you stop making payments on the loan.

You’ll receive an interest rate based on your credit history, the type of loan you’re applying for and the asset you’re securing. Loan terms for secured loans are often more favorable because your lender has the security of the asset you’re purchasing — it’ll get something of value if you’re unable to make payments.

An unsecured loan is one that a lender extends to you without an asset to secure it. Examples of unsecured loans include student loans and some personal loans. Your lender will qualify you for an unsecured loan based on your credit. With a secured loan, if you default on your mortgage, for example, your lender can take possession of your home. With an unsecured loan, this isn’t the case; there’s no collateral the lender receives if you don’t pay the loan back.

Unsecured loans tend to have higher interest rates, and their amounts are often smaller because of this. If you fail to pay an unsecured loan, your lender will report this to the main credit bureaus and collection agencies in an attempt to recoup the money.

How Do You Qualify for a Loan?

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To obtain a loan, you’ll need to submit certain information about yourself to the lender via an application. The process of applying for a loan will look different depending on the type of loan you want. Unless you’re borrowing from someone personally, almost all loans require a credit check, meaning your lender looks at your credit score and history to determine how risky you are to lend to — and how likely you’ll be to repay the loan. 

Your credit score says a lot about you. If you have a high score, it shows lenders that you’re responsible with your debt and you make your payments on time. A low score could mean you’ve missed a lot of payments, you’ve made payments late or you don’t have a lot of credit history built up.

In addition to your credit score, your lender will also need to verify your income. Your income will help determine if you can make your monthly installment payments or meet the terms of your loan. Your lender will also look at your debt-to-income ratio. This ratio refers to the amount of debt you have in relation to your income. Having too much debt can impact the amount of money you qualify to receive in your loan.

How Do You Apply for a Loan?

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Loan applications can differ from lender to lender, but they typically include similar details. When applying for a loan, you’ll need to provide some basic personal information, including your Social Security number and a valid ID. The lender will use these details to run your credit report. You’ll also need your latest pay stubs or other proof of income from your employer.

Lastly, your lender will likely review your current assets by looking at your bank statements. From there, additional documentation may be required. Once you’ve been pre-approved for an amount, you’ll continue on to the terms of your loan. You’ll choose a term length, find out your interest rate and sign on the dotted line. At this point, the bank funds your loan, and you’ll begin making your installment payments. Once you’ve repaid the loan in full, your loan obligation ends.

Loans and Borrowing 101

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When it comes to loans, it’s important to remember that some debt is good for your overall financial health. Student loans and auto loans, for example, are often some of the first loans a person takes out as they transition into adulthood. These will help boost your credit and build your credit history, which can impact your ability to obtain loans in the future. The better your credit and credit history are, the better the loan terms are that you’ll be offered for larger purchases. Responsible borrowing means sticking with loan amounts you can afford and comfortable loan terms that won’t stress your budget — or you.