Loans: How Loans Work
- A loan is an agreement between a borrower and a lender. The lender agrees to advance money and the borrower agrees to repay it.
- Loans have three main components – an interest rate, a loan amount, and a term (time to repay).
- Some of the most popular loans are personal loans, mortgage loans, auto loans, and student loans.
What are loans? Loans are agreements between borrowers and lenders. The lender agrees to advance a specific amount of money to the borrower. The borrower agrees to repay the loan in a way acceptable to the lender. People borrow money when they need to buy something and can’t or don’t have the money to pay for it.
How Do Loans Work?
Loans have three main elements – the amount borrowed, the loan term (time to repay), and the interest rate. Some loans may have additional components like loan fees, late charges, prepayment penalties, interest rate adjustments, collateral, or other items.
When you take out a loan, your lender advances you an amount of money now, and you promise to repay the loan plus interest. Interest (and often other fees) is how lenders earn money and stay in business.
Types of Loans
Loans can be classified in several ways depending on how you borrow or how you repay the money.
Secured vs unsecured loans
Loans can either be secured or unsecured. When you take out a secured loan, you pledge an asset that the lender can take and sell if you default (fail to repay your loan). The asset is called “collateral.” Mortgages and auto loans are secured loans.
Unsecured loans have no collateral attached to them. If you default, the lender may have to sue you for payment. This makes unsecured loans riskier for lenders and more expensive for borrowers. Credit cards and most personal loans are unsecured.
Installment loans vs revolving credit
Another way to classify loans is in how you repay them. With installment loans, the lender provides a lump sum of cash. You repay the loan in regular (usually monthly) installments. Each monthly installment covers the interest owed for that month plus an amount to decrease the balance. The lender calculates a loan payment that will zero out your balance by the end of the loan’s term. Mortgages, auto loans, and personal loans are examples of installment loans.
Revolving credit operates differently. The best example of revolving credit is the credit card. When you take out a revolving loan, you get the right to borrow up to a certain amount (your credit limit). You can borrow as little or as much as you want; you can pay the entire balance off or make a smaller payment and carry a balance from month to month. You can use, pay and reuse your credit line over and over as long as the account remains open and you make your payments as agreed.
Fixed rate vs variable rate loans
You can also classify loans by how their interest rates and payments work. Fixed-rate loans are simple and their rates and payments do not change. Most mortgages, auto loans, and personal loans are fixed-rate loans.
Variable-rate loans (also called adjustable-rate loans) are less predictable. Your interest rate and payment can change during the loan term. Typically, the interest rate is tied to a published financial index like the prime rate. The lender adds a percentage to this index to come up with your interest rate. If the index rises, your rate increases. If it falls, your rate goes down. Credit cards and some mortgages and personal loans have variable rates.
The most common loan products include mortgages, personal loans, auto loans, and student loans. Here are their most notable characteristics.
A mortgage is always a secured loan, and the collateral is always some form of real estate. Any loan secured by real estate is a mortgage. Mortgages can have fixed or adjustable (variable) rates, and they can be installment loans or lines of credit. One popular mortgage is a HELOC, which stands for home equity line of credit.
Because mortgages are secured by a valuable asset that can be taken and sold if you default, their interest rates are low. Mortgages are complicated because the lender needs to evaluate you and the property before approving the loan. And mortgages are subject to a lot of government oversight, which also adds to their cost.
Mortgage loan amounts range from under $100,000 to over $1 million. The most common terms are 15 and 30 years.
Personal loans can be secured or unsecured, but most are unsecured. Unsecured personal loans are also called “signature loans” because the lender's only security is your signed promise to repay the loan.
The most common personal loan is an unsecured installment loan with a fixed rate and payment. Very simple. Personal loans are riskier for lenders than mortgages and come with higher interest rates – in some cases, much higher.
Personal loan amounts range between $1,000 and $100,000, with terms between one and ten years.
Like mortgages, auto loans are secured loans. When you purchase a vehicle with an auto loan, that vehicle serves as the loan’s collateral. Auto loans are riskier for lenders than mortgages but don’t always carry higher interest rates. That’s because automobile manufacturers or dealers often offer loans at lower interest rates to market their cars.
Auto loans are installment loans with fixed interest rates and payments. This makes budgeting for their payments very easy.
You can find promotional auto loans advertised at zero percent, but most run between 4% and 6% for borrowers with good credit. The most common terms are 36 to 72 months.
Student loans are specialty products that follow different rules. You take out student loans to finance higher education. Student loans can be private or government-backed. If you default on a government-backed student loan, the government covers the balance – so the lender isn’t taking much risk. Other student loans are private, which means the government does not guarantee the loan.
Student loans are not secured by collateral (how could you possibly repossess someone’s education?), but lenders have almost more recourse with student loans than with any other financing. That is because it’s very difficult to discharge a student loan in bankruptcy. If you default, the government or your lender can garnish your paycheck, raid your bank account, or take your government benefits.
Fortunately, there are income-driven student loan repayment programs and student loan debt forgiveness programs available to you if you are eligible.
Shopping for a Loan
Loan interest rates and other terms vary widely among lenders, so it makes sense to shop around before committing to a product.
- Compare loan offers from several providers. Calculate the entire loan cost, including setup costs and payments over the loan term.
- Make apples-to-apples comparisons – make sure the loans have the same amount, repayment term, and rate type (fixed or variable).
- Read the fine print, and don’t commit to anything you don’t understand.
- Shop with lenders specializing in borrowers like you – in your credit score range and for your loan purpose.
You can contact lenders in person, by phone, or online. It doesn’t matter – what matters is that you do contact them.
What is a loan APR?
APR means annual percentage rate, and that’s the total cost of a loan, including interest and loan fees. It’s a required disclosure to help consumers compare loan products with different rates and costs.
For instance, which $10,000 loan is cheaper over five years? Loan A with $500 in costs and a 5.5% interest rate, or Loan B with $100 in fees and a 6% interest rate? Loan A has an APR of 7.03%, while Loan B’s APR is 6.41%. Loan B is cheaper.
What is a loan prepayment penalty?
A prepayment penalty is a charge you’d incur if you pay off a loan before a specified time. The only reason to accept a loan with a prepayment penalty is if it comes with a lower interest rate or costs, and you are reasonably sure that you won’t need to pay it off early.
What is loan underwriting?
Loan underwriting is the process of evaluating a loan application. When you apply for a loan, a lender considers your credit score, income, assets, employment stability, collateral (if applicable), and other factors. Loan underwriters can be software programs that decide in minutes or humans who take more time. Underwriting determines if you will be approved for a loan and how much you’ll be charged.