A loan is a sum of money that is borrowed with the intent of repaying the lender. It is debt that a borrower takes on and agrees to manage under terms and conditions set by the lender.
Principal and Interest
Every loans has two major components—principal and interest. The principal is the money that the borrower needs. Interest is the fee for borrowing the principal. Interest is calculated as a percentage of the balance, and is paid to the lender periodically. The amount is usually quoted as an Annual percentage rate (APR), but lenders calculate interest to last for the life of the loan.
For example, if a borrower takes out a $100 loan with 10% interest, they will repay the lender $110.
Loans either have fixed or variable interest rates. Fixed interest rates don’t change throughout the life of a loan or Investment. On the other hand, variable rates can change, depending on market conditions.
Installment loans vs. Revolving Credit
Lenders provide loans in two basic forms—installment loans and revolving credit.
Installment loans
An installment loan is dispersed in a lump sum, and repaid through a series of regular payments. Each payment is a portion of the principal plus the interest rate. Any additional origination (processing) fees associated with the loan are spread across installment payments until they are covered.
For example, getting a $500 loan with 20% interest makes the total amount of the loan $600. It could be repaid over a year with 12 monthly installment payments of $50.
Revolving Credit
While installment loans give lenders money all at once, revolving credit gives a borrower access to a line of credit that they can use at will. Instead of receiving a lump sum of $500, a borrower can use up to $500. So, if only $300 of the credit line is used, the borrower only repays $300.
Secured and Unsecured Loans
Secured loans are backed by collateral provided by the borrower. Collateral can come in property or holdings (like a savings account). If the borrower defaults on the loan, the lender can take the collateral to resell it to cover the lost return. Mortgages and auto loans are secured loans, with the home or car purchased serving as the collateral.
Unsecured loans are not backed by collateral. They are given based only on the borrower’s creditworthiness. The cost of an unsecured loan depends solely on the borrower’s credit history. Credit cards and student loans are unsecured loans.
On the whole, collateral makes secure loans less risky for a lender than unsecured loans. Because of that fact, secured loans typically have fixed interest rates and longer terms—which means that a lender can take more time to pay off the loan. Unsecured loans often have variable interest rates.
How to Apply for Loans
Various types of lenders provide loans:
Banks
Banks can provide unsecured loans, or secured loans for big purchases like homes and cars. The ideal bank loan comes from a bank that the borrower already does business with.
Credit unions
Credit unions are non-profit financial institutions that provide financial services like a bank. They typically provide lower interest loans for their members as they’re not concerned with making a profit.
Private Lenders
Private lenders provide the most options for a potential borrower. For example, some online private lenders offer loans that don’t require a credit check which you wouldn’t find at most banks or credit unions.
How to Choose a Lender
Choosing a lender ultimately depends on the borrower’s current financial need and ability to repay the loan. When reviewing any options, a borrower should understand these essential details:
- The total amount of the loan (including interest and fees)
- Interest rate (usually given as an APR)
- Schedule of installment payments (due dates and payment amounts)
Applying for a Loan
Every application has its different requirements. However, any potential borrower must provide a lender the following pieces of information:
- Government-issued identification
- Mailing address
- Proof of income
- Bank account information
- Active phone number and email address
After reviewing the application, the lender will determine whether or not to give the loan. If approved, the lender sends the requested amount to the borrower via check or an electronic deposit.
Repaying a Loan
It is important to make every payment on time when managing a loan. Making payments on time will help you avoid late fees and penalties that add to your balance. Some loans have prepayment penalties for repaying debt before the last payment is due.
Default
Default is the failure to repay a debt. A Default can occur when a borrower cannot make timely payments, misses payments, or avoids or stops making payments. The lender can take legal action against the borrower to recover the money owed. This action can include seizing assets and property, garnishing wages, and even taking away your driver’s license.
While good credit can get you lots of options, bad credit loans and quick cash loans can fit any financial need and budget. Before committing to any loan, a borrower should research several options to find the best combination of manageable interest rates and terms.
References:
Loan Etymology | etymonline