Many people use debt to finance purchases that they would not be able to afford otherwise, such as a home or a car. While loans can be excellent financial tools when used correctly, they can also be formidable adversaries. To avoid incurring too much debt, you should first learn how loans work and how lenders make money before borrowing money from eager lenders. In the financial world, loans are a big deal. They are used to generate revenue for lenders. No lender wants to lend money to someone without the assurance of receiving something in return. Keep this in mind as you look into loans for yourself or your business—the way loans are structured can be confusing and result in large amounts of debt. Before you borrow money, you should understand how loans work. With a better understanding of them, you can save money and make better debt decisions, such as when to avoid accumulating more and when to use it to your advantage.
Elements of a Loan
Before you borrow, it's a good idea to become acquainted with some key terms associated with all types of loans. The terms in question are principal, interest rate, and term.Principal
This is the initial amount of money borrowed from a lender and agreed to repay.Term
This is the length of time the loan will last. You must repay the money within this time frame. The terms of various types of loans vary. Credit cards are revolving loans, which means you can borrow and repay as many times as you want without having to apply for a new loan.Rate of Interest
This is the fee charged by the lender for borrowing money. It is typically a percentage of the loan amount1 and is based on the rate at which the Federal Reserve charges banks to borrow money overnight from one another. This is known as the "federal funds rate," which is the rate on which banks base their interest rates. The federal funds rate is the foundation for several rates, including the prime rate, which is a lower rate reserved for the most creditworthy borrowers, such as corporations. Smaller businesses and consumers with varying credit scores are given medium and high rates because they pose a higher risk to the lender.Loan Fees
Understanding any costs associated with a loan can help you decide which one to take out. When signing for a loan, costs are not always disclosed upfront and are usually expressed in financial and legal jargon that is difficult to understand.Interest Costs
When you borrow money, you are required to pay it back along with interest, which is typically spread out over the loan's duration. Different lenders may offer loans with the same principal amount, but if the interest rate and term are different, you will pay a different sum in total interest. When interest rates are considered, the costs to a borrower can be deceiving. The annual percentage rate (APR) of a loan is the most commonly advertised by creditors because it does not account for compounding interest paid over time. Tip: Look for loans with low-interest rates and no or minimal fees. For example, if you were promised a 6% APR on a $13,000 four-year auto loan with no money down and no other fees, you would pay a total of $1,654.66 in interest. A four-year loan may have higher monthly payments, but a five-year loan will cost you $2,079.59 in interest. To calculate loan interest, multiply the principal by the interest rate and the number of periods per year for the loan. However, not all loans are structured in this manner, and you may need to use a loan amortization calculator or an annual percentage rate to determine how much you will end up paying over the life of the loan. Amortization is the process by which money is applied to your loan's principal and interest balance. You make a fixed payment every period, but the amount is divided differently between principal and interest depending on the loan terms. Your interest costs per payment decrease over time as you make payments. The amortization table illustrates how a monthly payment is allocated to principal and interest. Amortization Schedule Payment Date Payment Principal Interest Total Interest Balance June 20XX $251.33 $186.33 $65.00 $65.00 $12,813.67 July 20XX $251.33 $187.26 $64.07 $129.07 $12,626.42 August 20XX $251.33 $188.19 $63.13 $192.20 $12,438.22Fees
Loan fees are sometimes required. Depending on the lender, you may be required to pay various fees. Here are some examples of common fees: Application fee: The application fee covers the cost of the loan approval process. Processing fee: A processing fee, like an application fee, covers the costs of administering a loan. Origination fee: The cost of obtaining a loan is referred to as the origination fee (most common for mortgages) Annual fee: A yearly flat fee paid to the lender (most common for credit cards). Late fee: The amount charged by the lender for late payments. Prepayment penalty: The cost of paying off a loan early (most common for home and car loans). Lenders rely on loan interest income to make a living. The prepayment fee is intended to make up for the fact that they won't get all the interest income they would have otherwise received if you hadn't paid off your loan early. If you pay off your loan early, they lose the amount of income for the number of years you won't be paying. These fees are not included in all loans, but you should be aware of them and ask about them when shopping for a loan. Beware of advance-fee loan scams. Legitimate lenders will never charge you a fee to "guarantee" your loan if you have bad or no credit or have filed for bankruptcy.Loan Qualification
To get a loan, you must first qualify. Lenders only make loans when they are confident that they will be repaid. Lenders use a few factors to determine whether you are eligible for a loan or not. Because it shows how you've used loans in the past, your credit is an important factor in helping you qualify. A higher credit score increases your chances of obtaining a loan at a reasonable interest rate. You'll almost certainly need to demonstrate that you have enough income to repay the loan. Lenders frequently look at your debt-to-income ratio, which compares the amount you owe to your earnings. If you don't have good credit or are borrowing a large sum of money, you may be required to secure the loan with collateral, which is known as a secured loan. If you are unable to repay the loan, the lender may take something and sell it. You may even need to have someone with good credit co-sign on a loan, which means they will be responsible for paying it if you are unable to.Loan Application
When you want to borrow money, you go to a lender and apply for a loan, either online or in person. A good place to start is with your bank or credit union. Working with specialized lenders such as mortgage brokers and peer-to-peer lending services is also an option. After you provide personal information, the lender will review your application and decide whether or not to grant you the loan. If you are approved, the lender will send funds to you or the entity you are paying—for example, if you are buying a house or a car, the funds may be sent to you or directly to the seller. Shortly after receiving the funds, you will begin repaying the loan on an agreed-upon recurring date (usually once a month) at a pre-determined interest rate. Please keep in mind that lenders may sometimes restrict how you can use funds. To avoid getting into legal trouble, make sure you are aware of any restrictions on how you use the borrowed money.Questions and Answers (FAQs)
How do you repay a loan?
The details of how to repay your loan will be included in your loan agreement, and the exact setup will depend on your loan type and terms. You'll generally make a payment by the due date every month. You can usually set it up each month as an automatic draught or mail a check to your lender. You can also make extra payments toward principal to pay off your loan faster if your loan allows it.How do I calculate my loan's monthly payment?
Your loan agreement will list your monthly payment amount and due date and any monthly statements mailed to you by your lender. You can most likely create an online account with your lender and check your payment information online as well.Can I make changes to my loan payment?
You can always increase your payment amount to pay off your loan sooner if your loan does not have an early payoff penalty. If you want to pay a lower monthly payment, you'll need to refinance your loan to a lower amount or a longer payoff term.