What Is a Loan & Is It a Good Idea?
If you have a large expense, a loan can be a useful way to help cover the cost, but what is a loan?
It’s important to understand everything that borrowing money entails before you apply for a loan.
If you’re considering a small personal loan or a big loan to buy a home or a car, understanding what a loan is and how it works will save you money and frustration.
Let us walk you through the loan terminology, types of loans and borrowing process so you can make an informed decision.
As experts in our field, we discuss the following in this article:
We’ve done the research to provide you with the most up-to-date information on loans in 2022.
Here’s what we found about loans.
What’s a Loan?
A loan is an amount of money you borrow and agree to pay back within a specified timeframe, usually with interest.
The key characteristics of a loan are:
- It has to be paid back within a specified timeframe.
- The lender will charge interest on the total amount that you borrow.
- You pay the loan off in regular installments.
- A loan term is usually years.
The amount you can borrow and the interest rate the lender will charge you depend on your credit score and how long you’ll take to repay the loan.
Why Do People Take Out Loans?
People take out loans for many reasons, for example:
- To buy a car.
- To pay for a wedding or special event.
- To pay for college.
- To cover the cost of home improvements.
- To consolidate debt.
- To expand a business.
- To finance a new business venture.
How Loans Work
Loans take place when a person borrows money, usually a lump sum, from a lender.
The borrower has to make regular, monthly repayments for a specified period until they repay the entire loan.
Besides paying the loan amount, the borrower pays interest at a rate determined by the lender and any lender fees.
The lender includes the interest and fees in the monthly repayment amount.
Loan principal is the loan amount or the amount of money borrowed to be paid back under the loan agreement.
A lender can decide to add its fees to the principal, which will make the loan principal higher than the actual amount borrowed.
When the borrower makes monthly payments, part of the payment goes toward paying off the accrued interest and what remains toward paying the loan principal.
The minimum monthly payment required to pay off a loan is the amount needed to pay off the loan principal and interest within the specified loan timeframe.
Any payments the borrower makes over and above the minimum payment it applied to the loan principal.
The loan term is the specified timeframe the borrower has to pay back the loan.
It is determined by the terms the lender offers and the borrower’s creditworthiness.
Loans with longer terms result in smaller repayments, but the borrower usually pays more interest over the loan term.
Loan terms for personal loans range from 2 to 7 years, whilst the average term for auto loans is 6 years.
Student loans are often longer and can last up to 10 years.
Mortgages have the longest loan term of 15 to 30 years.
Interest & Fees
Interest & fees are what the lender charges the borrower for giving them the money.
The interest rate is the cost of borrowing the money charge to the lender by the borrower.
The annual percentage rate (APR) is the total annual cost over the life of the loan. It includes the interest rate and finance charges.
Finance charges include closing costs and origination fees.
Lenders use interest rates and APRs to advertise loan offerings. This allows borrowers like you to find the most competitive rates.
Lenders mostly offer rates between 10% & 28%. A good interest rate on a personal loan is one that’s lower then an average of 12%.
Mortgage lenders charge rates between 3% and 8%.
Rates offered by lenders vary according to the borrowers creditworthiness, the loan amount and other factors.
Additional fees lenders charge when extending loans include:
- Application fee. Lenders sometimes charge application fees. Look for lenders who offer free applications.
- Origination fee. This fee covers the cost of processing applications, including verification of borrower information. Personal loan origination fees range between 1% to 8%.
- Late payment fee. Lenders can charge fees when borrowers make late payments or for payments that are returned because of insufficient funds.
- Prepayment penalty. Some lenders charge a fee for paying off a loan early. Look for lenders who offer no prepayment penalty.
Simple vs Compound Interest
Simple interest is interest calculated on the principal loan.
Compound interest is interest on interest, meaning the lender applies interest to the principal loan and the accumulated interest from previous periods.
Banks rarely charge simple interest, mostly they charge compound interest.
With compound interest
The borrower owes the lender the principal loan amount plus interest for the year in the first year.
In the second year the borrower owes the lender the principal loan amount and interest for the first year plus interest on the interest for the first year.
Compound interest means the interest owed is higher than simple interest because the lender charges monthly interest on the principal loan plus the accrued interest from previous months.
With shorter loan terms, the interest calculation is similar for both simple and compound interest. However, as the loan term increase the difference between the two increases.
Qualification requirements to get a loan vary between lenders.
However, common qualification requirements include:
- Debt-to-income ratio (DTI). The amount of income a borrower brings in every month vs what they pay toward monthly debt.
- Credit score. A borrower’s credit score is an indicator of creditworthiness and represents the borrower’s level of risk.
- Income. A borrower’s income determines their ability to repay a loan.
- Stable employment. A borrower with stable employment is more likely to continue to have sufficient income in the future.
Types of Loans
Types of loans include secured or unsecured loans. A secured loan requires collateral, usually a valuable asset. An unsecured loan doesn’t require collateral.
Lenders classify loans as revolving or term. With a revolving loan, you can access funds as needed. With a term loan, you receive a lump sum and repay the full amount over a specified time period.
Secured vs Unsecured Loan
Secured loans require collateral in the form of something of value, for example, a home or a vehicle.
If a borrower cannot pay back the loan, the lender can repossess or seize the collateral to recoup the outstanding loan. Secured loans pose less risk to lenders
Attract lower interest rates. Common examples of secured loans are auto loans and mortgages.
Unsecure loans don’t require collateral and the lender cannot seize any valuable asset if a borrower defaults on payments.
Unsecured loans pose more of a risk to the lender and therefore attract higher interest rates.
Common examples of unsecured loans include student loans and personal loans.
Revolving vs Term Loan
A revolving loan involves a lender extending credit with a set limit that the borrower can access as needed. The lender charges interest on the outstanding balance only.
A term loan involves a borrower receiving a lump sum payment upfront. The borrower pays the loan back over a specified time period in regular installments.
Term loans are usually from 2 to 7 years and borrowers have to pay interest on the entire loan amount at a fixed or variable rate.
Things to Consider Before Taking Out a Loan
Consider all your options before applying for a loan.
Do you need the item you want the loan for now?
Could you look at saving the money you need or a portion of the money you want to loan?
You’ll want to make sure you build up an excellent credit history. Having a good credit score will give you better options on interest rates and types of products to choose from.
When you look at loans check the different interest rates being offered to find the best one for you.
Don’t forget to read the fine print on any products a lender offers you.
Know what your repayments will be and create a budget to make sure you can afford the repayments.
Repaying Your Loan
Repaying your loan is important. You need to make sure that the repayments fit into your budget.
We recommend that you set up a direct debit so that the repayments happen automatically. Make sure that you have enough money in your account to cover the repayments.
Failure to make repayments will result in penalty payments and can negatively impact your credit score.
Are Personal Loans Secured or Unsecured?
Personal loans are usually unsecured.
This means that the lender cannot seize any assets if you fail to repay the loan.
However, failure to repay you loan will incur penalties and negatively affects your credit score.
What’s the Difference Between a Loan & a Credit?
A loan gives you all the money you request as a fixed amount in one payment.
This amount, plus the agreed interest, has to be repaid within a specific timeframe. There is no option to access more money unless you apply for a new loan.
Loans have longer terms, usually years.
A credit gives you an amount of money that you can use as you choose. It is more flexible as a credit has a maximum limit and the borrower can use all or part of the money at any time.
You pay interest on the amount that is used and when you pay back the money you borrow it becomes available to you again.
The interest rate on a credit is usually higher than that of a loan.
Lenders usually renew a credit every year to allow the borrower continued access to the credit.
When’s the Right Time to Get a Loan?
The right time to get a loan is after careful consideration of your options.
If you have a high credit score and you can afford loan repayments, a loan is sometimes a better alternative to a credit.
If your financial situation allows you to get a loan, these are situations where a loan would be appropriate:
- Home improvements.
- Consolidation of high interest debt.
- Large purchases.
Is a Loan or Credit Card Better?
A loan and a credit card both provide a way for you to borrow money, which one is better for you depends on your needs and circumstances.
A loan is a better option for borrowing larger amounts of money over a longer timeframe.
Interest rates for loans are usually lower than credit cards and you can set a repayment term which will affect your installment payments.
A credit card may be a better option if need to borrow smaller amounts regularly.
They are also a good option if you want to have extra funds available in case you need it or you’re not sure how much you need to borrow.
Interest rates for credit cards are higher than loans so you’ll need to make sure you can afford the repayments.
A loan is when a lender gives you money and you agree to repay the loan principal plus interest within a specified time.
Both the lender and the borrower agree on loan terms and interest rates before they give money.
Loans can be secured with collateral (e.g. mortgages) or unsecured with no collateral.
Credit cards or revolving loans give you money you can spend, repay and spend again. Loans offer a fixed amount that is paid back over a fixed term.
Loans have longer terms, usually years with lower interest rates than credit.
If you have a good credit score and can afford the monthly payment, a loan gives you access to a lump sum of money that you can use to make large purchases.
Editorial Note: This content has been independently collected by the EveryInvestor team and is offered on a non-advised basis. EveryInvestor may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations. Learn more about our editorial guidelines.