Many people take on debt in order to finance items that they would not be able to afford in any other way, such as a home or a car, and this is common. When utilized appropriately, loans may be extremely useful financial instruments; nevertheless, they can also be quite challenging obstacles to overcome. Before you start borrowing money from eager lenders, you should have an understanding of how loans operate and how money is made for the lenders. This will help you avoid taking on an excessive amount of debt.
What is Loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient incurs a debt and is usually liable to pay interest on that debt until it is repaid as well as to repay the principal amount borrowed.
In the realm of finance, loans represent a significant market opportunity. They are put to use in order to generate income for the lenders. Nobody who lends money wants to do business with someone who cannot guarantee a return on the investment. When looking into loans for either yourself or your company, keep this fact in mind. The way loans are constructed can be difficult to understand and lead to significant amounts of debt.
Before taking out a loan for money, it is essential to have a solid understanding of how the process works. If you have a better grasp of them, you will be able to save money and make more informed decisions regarding debt, such as knowing when it is best to refrain from taking on further debt and when and how to use it to your benefit.
Types of Loans
Student loans are meant to pay for tuition, fees and living expenses at accredited schools. This means that you generally can’t use student loans to pay for specific types of education, such as coding bootcamps or informal classes.
There are two types of student loans: federal and private. You get federal student loans by filling out the Free Application for Federal Student Aid (FAFSA) and working with your school’s financial aid department. Federal student loans generally come with more protections and benefits but charge slightly higher interest rates. Private student loans come with much fewer protections and benefits, but if your credit is good, you could qualify for better rates.
Mortgages help you finance the purchase of a home, and there are many types of mortgages available. Banks and credit unions are common mortgage lenders; however, they may sell their loans to a federally-sponsored group like Fannie Mae or Freddie Mac if it’s a qualified mortgage.
There are also government-backed loan programs available for certain groups of people, including:
- USDA loans for rural, low-income home-buyers.
- FHA loans for people with low- to moderate-income levels.
- VA loans for active-duty service-members and veterans.
Personal loans are the broadest type of loan category and typically have repayment terms between 24 and 84 months. They can be used for just about anything except for a college education or illegal activities. People commonly use personal loans for things like:
- Medical treatment
- Home renovations
- Debt consolidation
- Relocating to a new city
- Computers or other pricey electronics
Personal loans generally come in two forms: secured and unsecured. Secured loans are backed by collateral—such as a savings account or a vehicle—that a lender can take back if you don’t repay your full loan amount.
Unsecured loans, on the other hand, require no collateral and are backed by your signature alone, hence their alternate name: signature loans. Unsecured loans tend to be more expensive and require better credit because the lender takes on more risk.
Applying for a personal loan is easy, and typically can be done online through a bank, credit union or online lender. Borrowers with excellent credit can qualify for the best personal loans, which come with low interest rates and a range of repayment options.
Family loans are informal loans that you get from family members (and sometimes friends). You may choose to turn to family if you can’t qualify for a traditional loan from a bank or lender, for example.
Family loans can be useful because you don’t need any credit to get one. If your family member trusts you and they have the financial means to do so, they can choose to give you the loan.
But that doesn’t mean you should take advantage of your family member’s generosity. It’s still a good idea to draft up and sign a loan agreement, including interest payments, due dates, late fees or other consequences for non-payment. You can find draft agreements and payment calculators online to help you do this.
Auto loans are a type of secured loan that you can use to buy a vehicle with repayment terms between three to seven years. In this case, the collateral for the loan is the vehicle itself. If you don’t pay, the lender will repossess the car.
You can typically get auto loans from credit unions, banks, online lenders and even car dealerships. Some car dealerships have a financing department where they help you find the best loan from partner lenders. Others operate as “buy-here-pay-here” lenders, where the dealership itself gives you the loan. These tend to be much more expensive, though.
Key Loan Elements
It is in your best interest to have a basic understanding of the terminology related with loans of all kinds before you take out any kind of credit. Principal, interest rate, and the length of the contract are the terms in question.
This is the initial sum of money that you will borrow from a lender — and confirm that you will pay back — in exchange for the loan.
The duration of the loan is represented by this number of years. You are obligated to return the money within this certain amount of time. 1 The terms for the various kinds of loans are all different. 3 Since credit card loans are considered revolving loans, cardholders are permitted to borrow and return money on their cards an unlimited number of times without having to reapply for new loans.
You will be required to pay the lender this sum in order to borrow money from them. It is often expressed as a percentage of the total amount borrowed1, and its quantity is determined by the interest rate at which the Federal Reserve charges banks to borrow money from each other overnight. 5 This is the rate that banks use to determine their own interest rates, and it is referred to as the “federal funds rate.”
The federal funds rate serves as the foundation for a number of other rates, including the prime rate, which is a lower rate that is set aside for the borrowers with the highest creditworthiness, such as companies. After that, individuals that pose a greater risk to the lender, such as less significant companies and customers with a wide range of credit ratings, are offered rates that are medium to high.
Fees and Interest That Are Associated With Loans
If you are trying to decide between several different loans, it is helpful to have a thorough understanding of the fees that are involved with each option. When applying for a loan, the costs are not always disclosed up front, and when they are, it is typically in a financial or legal jargon that can be difficult to understand.
The costs of interest
When you take out a loan, you are responsible for repaying the principal amount plus interest, which is typically amortized over the course of the loan’s duration.
8 You can acquire a loan from many lenders for the same principal amount, but if the interest rate and/or duration is different for each loan, the total amount of interest that you will pay will be different for each loan.
When interest rates are taken into consideration, the costs incurred by a borrower can be quite misleading. The annual percentage rate, often known as the APR, is the interest rate that is most commonly promoted by lending institutions. This rate does not take into account the interest that is compounded over the course of many payment periods.
For instance, if you were given an annual percentage rate (APR) of 6 percent on a $13,000 vehicle loan for four years with no money down and no extra fees, and the interest was compounded monthly, the total amount of interest you would pay would be $1,654.66. There is a possibility that your monthly payments could be lower with a four-year loan, but the interest on a five-year vehicle loan will amount to $2,079.59 more.
Multiplying the loan’s principle by the interest rate and the number of payment periods that occur in a year for the loan is one straightforward method for calculating the interest on the loan. However, not all loans are structured in this manner, and it is possible that you may need to use a loan amortization calculator or an annual percentage rate calculator in order to figure how much you will ultimately wind up paying for the loan over the course of its duration.
The process through which money is subtracted from the principle and interest amount of a loan is referred to as “amortization.”
You are required to make consistent payments of a certain amount, but the loan conditions determine how much of each payment goes toward the debt and how much goes toward the interest. Your interest expenses will be reduced on a per-payment basis as time goes on and you make payments.
An illustration of how a monthly payment is allocated to principle and interest is shown in the table that summarizes the amortization process.
When you take out a loan, you may occasionally be required to pay fees. The lender you go with might have a significant impact on the kinds of costs you wind up having to pay. The following are some examples of common kinds of fees:
The application fee is used to cover the costs associated with granting a loan.
A processing charge is a fee that covers the costs connected with the administration of a loan. It is comparable to an application fee.
The cost of obtaining a loan is known as the origination charge (most common for mortgages)
Annual fee: A predetermined sum of money that must be paid to the lender on an annual basis (most common for credit cards).
A late fee is the amount that the lender charges you for making payments that are late.
A prepayment charge is the expense that is incurred when a loan is paid off early (most common for home and car loans).
Interest is the primary source of revenue for lenders. When you pay off your loan early, they lose the amount of revenue that corresponds to the number of years during which you would not be making payments; the prepayment charge is intended to compensate them for the loss of the interest income that they would have received if you hadn’t paid it off early.
Although not all loans have these costs, you should keep an eye out for them and inquire about them if you are contemplating applying for a loan.
Getting Approved for a Loan
To acquire a loan you’ll have to qualify. Lenders will only provide financial assistance if they are confident that they will be repaid. Lenders will consider your application based on a number of criteria in order to decide whether or not they will grant you a loan.
Because it demonstrates how you’ve handled debt in the past, your credit score is an essential component in determining whether or not you will be approved. If you have a higher credit score, then you will have a better chance of being approved for a loan at an interest rate that is fair.
You should also be prepared to demonstrate that you have sufficient revenue to be able to repay the loan. Your debt-to-income ratio refers to the amount of money you owe in comparison to the amount of money you make. Lenders will frequently look at this ratio.
If you do not have good credit or if you are borrowing a significant amount of money, you could be required to secure the loan with collateral, in which case you would have what is known as a secured loan.
In the event that you are unable to repay the loan, the lender has the right to seize and sell any collateral that has been pledged as security. 22 You may even be required to have someone with strong credit co-sign on the loan with you. This means that they will be responsible for the payment of the loan in the event that you are unable to.
Making an Application for a Loan
When you are in need of financial assistance, the first step is to approach a lending institution (either physically or virtually) and submit an application for a loan. The first place you should look is at your bank or credit union. You also have the option of collaborating with professional lenders such as mortgage brokers and firms that facilitate peer-to-peer financing.
After you have provided the lender with information about yourself, 24 they will review your application and make a decision regarding whether or not to grant you the loan. If your application is accepted, the lender will transfer the cash to either you or the entity that you are paying. For instance, if you are purchasing a house or a car, the money might be given to either you or straight to the seller.
You will begin making payments on the loan not long after you have received the funding, on a reoccurring date that has been agreed upon (often once per month), and at a rate of interest that has been set in advance.
How to Get a Loan In 5 Steps
While the process varies by lender, follow these general steps to get a loan:
Check your credit score. Start by checking your credit score for free through your credit card issuer or another website that offers free scores. This will give you an understanding of your creditworthiness and your qualification chances. Check with your desired lender for minimum credit score requirements.
If necessary, take steps to improve your credit score. If you have damaged credit or you want to boost your score to receive the best terms possible, take time to improve your score before applying, such as lowering your credit usage or paying off unpaid debts.
Determine how much you need to borrow. Once you check your credit score, calculate how much money you want to borrow. Remember, though, you’ll receive your money as a lump sum, and you’ll have to pay interest on the entire amount—so only borrow what you need.
Shop around for the best terms and interest rates. Many lenders will let you prequalify prior to submitting your application, which lets you see the terms you would receive with just a soft credit inquiry. Prequalifying lets you shop around for the best rates without hurting your credit score.
Submit a formal application and await a lending decision. After you find a lender that offers you the best terms for your situation, submit your application online or in person. The amount of time it takes to process your loan depends on the lender.
Understand the 5 C’s Of Credit Before Applying for a Loan
The five C’s of credit offer lenders a framework to evaluate a loan applicant’s creditworthiness—how worthy they are to receive new credit. By considering a borrower’s character, capacity to make payments, economic conditions and available capital and collateral, lenders can better understand the risk a borrower poses.
Character. To evaluate a borrower’s character, lenders may look at an applicant’s credit history and past interactions with lenders. Likewise, they may consider the borrower’s work experience, references, credentials and overall reputation. This helps determine whether the applicant is responsible and likely to make on-time payments on loans and other debts.
Capacity. Capacity summarizes a borrower’s ability to repay a loan based on the applicant’s available cash flow. When evaluating this, lenders consider whether the borrower can cover new loan payments on top of their existing debt service. Relevant factors include the borrower’s income and income stability.
Capital. Lenders want to see that you’re committed enough to contribute some of your own funds. In the case of a business loan, lenders evaluate the investments a borrower has made into the business, including inventory, equipment and a point of operations. For mortgages, auto loans and other major purchases, lenders look at the down payment size the borrower is committing to the purchase.
Conditions. In addition to a borrower’s personal finances, lenders also look at other financial conditions like the overall health of the economy and specifics of the loan. This typically includes the interest rate, amount of principal and loan purpose. However, lenders also consider outside factors like the state of the economy, industry trends (in the case of a business loan) and other conditions that might impact loan repayment.
Collateral. Collateral is an asset a borrower pledges to secure a lender’s interests in making the loan. If the borrower defaults on the loan, the lender can repossess the asset to recoup their losses. A borrower’s ability—and willingness—to pledge valuable collateral reduces the risk to the lender. For example, when taking out a mortgage, the real estate serves as the collateral; with an auto loan, the collateral is the car.