How Do Loans Work?
By understanding how loans work, you can borrow money safely and at the lowest cost
A loan is far from free money; it’s an amount that you borrow and agree to repay under specific terms. Usually a formal agreement, loans involve two parties: the borrower and the lender. The contract specifies the terms and conditions of the loan, and once you sign, you are legally obligated to adhere to it.
Before pursuing and taking out a loan, learn how they work and how you can borrow smartly, safely and at the lowest possible cost.
Loans Basics : How it Work
These are the essentials on how loans work:
- You take out a loan when you borrow money from a lender.
- The amount you borrow is paid back over time, plus interest and applicable fees.
- Lenders will require an application and consider your credit rating, income and other factors when determining loan approval.
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Interest rates are determined by your credit rating and other qualifying factors. They can be fixed or variable.
Your loan’s term is the amount of time you take to pay back the amount borrowed. Loan terms vary depending on loan type, lender and your credit rating.
Considering how much you need to borrow and comparing loan terms across different lenders could help you save money.
The concept of loans is simple on the surface: You borrow money and pay it back. But it’s worthwhile to dig deeper. The more you understand, the better you can avoid financial trouble. Being knowledgeable can help you borrow the right amount of money, agree to an affordable payment and payoff term, and find the best interest rate you can qualify for.
Misconceptions can lead to financially unsound decisions. For example, according to a 2018 Student Loan Hero survey, 52% of the respondents didn’t know that interest accrues on federal unsubsidized loans while they’re enrolled in school, and 47% believe that loans in forbearance don’t accrue interest (they do). Borrowers who delay payments for this reason could be in for an expensive surprise.
Loan Types Available : What Loans Will Work For You
There are two basic types of loans: secured and unsecured. Secured loans are collateralized by money in a separate account, the property you purchase or other assets, such as your home or vehicle. If you don’t repay as agreed, the lender can claim the collateral to pay off the debt. Because of this guarantee, the lender’s level of risk is low.
Unsecured loans do not require collateral, so they are more of a gamble for the lender. “The largest risk a bank takes on in unsecured lending is the ability to collect if the customer quits paying,” says David Reiling, CEO and president of Sunrise Banks. To get the money back, the lender might have to refer the account to a collection agency or sue for damages.
Then, there are different loans for different purposes. Most are offered by banks, credit unions and online lenders. Common loan types include:
can be used to pay for nearly any use, though some lenders have restrictions such as no business or education use. They are often used to consolidate existing debt or finance an upcoming expense, like a wedding. Most are unsecured, though secured personal loans are available.
are for launching or operating a business. They may be secured (with cash in deposit accounts, property, or business or personal assets) or unsecured.
are for higher education costs. Federal student loans are offered through the U.S. Department of Education, including undergraduate, graduate and parent loans.
are used to buy a vehicle such as a car or truck and are typically secured by the vehicle.
also known as mortgages, help people buy real estate. As with car loans, the property you purchase usually acts as security for the loan.
The Loan Process
Some types of loans are more involved than others. For example, you may have to submit extensive paperwork in underwriting for mortgages or business loans. But the overall process is fairly consistent with all loan types.
Some lenders offer prequalification or preapproval, but to actually obtain a loan, you’ll ultimately need to fill out an application. A loan application will ask for personal information, typically your name, date of birth, Social Security number, address, phone number and email address.
You’ll typically need to include income and employment details. Some loan types may require details about your assets (cash in savings and investment accounts, as well as any property) and liabilities (your financial obligations).
Once your application is received, the lender will assess it for approval. This is also known as underwriting. With most loans, this is when a lender will check your credit report and score. At this point, the lender will decide whether you’re approved for the loan and if so, what terms you qualify for, such as the loan amount and annual percentage rate. For some loans, like mortgages, loan processing and underwriting may include appraisal, inspection and other steps to gather more information about the property or your financial status.
If you qualify for the loan, the funds will be disbursed to you or a designated recipient, such as a title company for mortgages. Disbursement may also be referred to as loan closing. Disbursement time can vary widely depending on loan type and individual lenders. Online lenders may offer access to funds within 24 hours with an electronic deposit. Disbursement for other loans can take longer. For example, it can take two weeks to two months for a private student loan to be sent to you or your college. Whenever and wherever the money lands, it becomes your debt once it’s disbursed.
Paying the balance:
The payment amount and due date will be listed on the agreement you signed. A portion of your payment will go toward financing, and the rest will be applied to the principal. If the lender uses the simple interest method, interest will be calculated on the outstanding balance due.
If you increase the payment, interest fees will decrease along with your debt. On the other hand, if the lender precomputes interest, the interest for the term of the loan is already factored in, so you won’t reduce interest if you pay the loan early.
The lender may report activity on the loan to the three credit reporting agencies: Experian, TransUnion and Equifax. Paying on time can improve your credit rating and save you money by avoiding late fees. Reiling recommends taking advantage of automatic bill payment options so you don’t forget to make a payment.
You might want to change your loan’s terms at some point – for example, getting a lower interest rate or extending your loan’s repayment term. Refinancing is essentially getting a new loan to pay off an older one, ideally with better terms.
“If your credit was not perfect when you got the loan, but it’s better now, you (could) probably qualify for a better interest rate,” says Brendan Coughlin, president of consumer deposits and lending at Citizens Bank.
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What to Look for When Loans Shopping
Remember that, as a borrower, you have the power to choose which loan type works best for you. Research the best terms that you can qualify for, then borrow prudently.
When comparing loan products, consider each loan’s:
Is getting a loan a good choice in the first place? “It comes down to distinguishing good debt versus bad debt,” says Coughlin. “Good loans add value and are within your means. These are usually for a home, car, kids’ education, to redo a bathroom or to fix a roof. Bad debt is for discretionary purchases, such as for vacations and boats, and puts you financially behind.”
Comparing interest rates could save you money if you’re able to choose a loan with a lower rate. But a rate that starts low could increase later if you obtain a loan with a variable rate. Variable rates are tied to a benchmark that fluctuates, such as the prime lending rate. If the interest rate is fixed, it will remain the same for as long as you have the loan. Fixed interest rates may start higher than variable rates, but the risk of the variable rate hiking up may be unattractive for some borrowers.
The term is the amount of time you have to pay the loan off. For a personal loan, a term of two to five years is typical. Other loans can have much longer terms. According to a recent Experian survey, 72 months (six years) is the most common car loan term. The standard repayment period for a federal student loan is 10 years, and a mortgage is typically 30 years.
You can pay any loan off early, but know going into it what the potential downsides may be. For example, you could lose tax advantages of paying for student loans and mortgages, since interest paid on them is often tax deductible. If the loan comes with a prepayment penalty, the fee will be added to your payoff amount.
You have to be absolutely sure that you can easily handle a loan’s payments, not just in the beginning, but for the entire lifespan of the loan. “Ask yourself if you can really afford it easily,” Coughlin says. Plan for all potential changes in your life, including employment, children and the extra expenses.
All will impact the amount of money you have left to devote to the loan. The longer the loan’s term, the lower the monthly payment, but the more you’ll ultimately pay in interest.
It’s always a good idea to research a lender before doing business with it. Read as many consumer reviews as possible. The lender should be easy to communicate with, and the agreement should be clear.
And finally, says Reiling, read the fine print before you sign any loan agreement. “You always want to make sure all of the terms are written as you remembered or discussed. Do not hesitate to ask the lender questions. That’s what you’re supposed to do.”