A loan takes place when a lender, such as a traditional bank or an online lender, grants a fixed amount of money to a borrower. In return, the borrower agrees to repay the loan at a specified interest rate over a specified loan term. Whether you are considering a small Personal loan or a larger loan to buy a home or vehicle, understanding what loans are – and how they work – can help save you money and frustration.
We will guide you through loan terminology and common types of loans to inform the borrowing process. To learn more about loans, keep reading in this article
How loans work
In general terms, a loan involves borrowing a lump sum from a lender and making regular (often monthly) payments until the loan is fully repaid. Beyond repaying the principal of the loan, the borrower must pay interest at a fixed rate as well as additional charges from the lender. To understand how loans work, familiarize yourself with some common terms.
Principal of the loan
The loan principal is the amount of money that a borrower agrees to repay under a loan agreement. In most cases, the principal equals the loan amount. However, if a lender applies a charge to the principal – rather than deducting it from the cash disbursement – the principal will be greater than the actual amount borrowed.
Once a borrower begins making loan payments, a portion of each payment is paid toward accrued loan interest, and the lender applies the remaining portion to the principal of the loan. The minimum monthly payment is what is required to repay the principal and interest on the loan during the life of the loan. If a borrower makes payments above the minimum, the lender applies the surcharge against the principal.
term of the loan
A term of the loan is the time available to the borrower to repay the loan. Also called the term, the duration of a loan depends on the creditworthiness of the borrower and the repayment terms offered by the lender. Longer-term loans are characterized by smaller payments, but the borrower may pay more interest over the life of the loan.
The terms of personal loans generally vary from two to seven years, although they can be as short as six months or as long as 12 years. The average term for an auto loan is six years, but it can range from two to eight years. Student loans are longest, most last 10 years, and mortgages are typically the longest at 15 or 30 years.
Note: “Loan terms” can also be used to describe the loan terms. In this case, the term of the loan refers to characteristics such as the annual percentage rate, the amount of the monthly payment, the fees, the due date of the monthly payment and the length of the term.
Interest and fees
The interest rate on a loan is the money the lender charges the borrower to access the money – or the cost of borrowing the money.
Likewise, the annual percentage rate (APR) is the total annual cost over the life of the loan. This includes the interest rate as well as additional finance costs such as closing costs and set-up costs. Interest rates and available APRs are often used to advertise loan offers, so look for the most competitive rates when shopping for a loan.
Personal lenders typically offer rates between 10% and 28%, but a good interest rate on a personal loan is that which is lower than the national average by about 12%. Mortgage lenders, on the other hand, typically charge rates between 3% and 8%. Having said that, the exact rate a lender offers a borrower will depend on their creditworthiness, the amount of the loan, and other factors that affect the amount of risk borne by the lender.
Additional fees that a lender may charge when extending a loan include:
- Registration fees. Some lenders charge an application fee to cover the costs of processing the application. However, many lenders offer free loans, so be aware of this when shopping for a bank or lender online.
- Origination fees. The origination fee covers the cost of the lender for processing applications, verifying the borrower’s income, and even marketing their loan products and other services. Personal loan origination fees Usually vary from 1% to 8% of the loan amount, but the fees vary depending on factors like the borrower’s credit history.
- Late payment fees. Lenders often charge a fee when a borrower makes a late payment or if a payment check is returned for insufficient funds. Having said that, lenders who offer no-fee loans may not impose these penalties.
- Penalty for early payment. Some lenders also charge borrowers a fee – or prepayment penalty—To pay off their loans early. Prepayment penalty amounts are usually a percentage of the outstanding loan balance and start at around 2%. Notably, many lenders choose to stay competitive by completely avoiding prepayment penalties.
Paying off a loan is the process of paying off a loan, usually on a monthly or quarterly basis and in fixed amounts. A portion of each payment goes towards interest, and the remaining portion is charged against the principal of the loan. Payments must be made in accordance with the terms of the loan, as set out in the loan agreement.
To be eligible for a loan, potential borrowers must meet certain eligibility requirements that vary by lender. Common qualification requirements include:
- Debt-to-income ratio. A borrower debt to income ratio (DTI) represents the amount of income it earns each month relative to the share of that income that goes toward monthly debt service. Lenders generally prefer borrowers with a DTI below 36%, but this requirement varies by lender.
- Credit score. Credit scores indicate the creditworthiness of a borrower and tell the lender whether the applicant has a high level of risk. A borrower’s credit rating is made up of several factors, including credit history, credit utilization rate and credit composition. On average, the minimum FICO credit score needed to qualify for a loan is between 610 and 640; applicants with scores above 690 are more likely to qualify for competitive rates.
- Returned. Much like DTI, income demonstrates a borrower’s ability to repay a loan. While some lenders publish minimum income requirements, others prefer to assess a borrower’s income adequacy on a case-by-case basis. Minimum income requirements vary by lender and many lenders do not publish them.
- Steady job. Stable employment indicates to a lender that a borrower is likely to have sufficient income in the future.
Types of loans
In general, a loan may or may not be secured, which means that you may be required to pledge a valuable asset at guarantee the loan. Likewise, loans can be classified as revolving, if funds are accessed on a revolving basis, as needed; or over time, when the loan is disbursed as a lump sum and repaid over a specified period of time.
Secured or unsecured loans
Secured loans are secured by something of value – like a house or a vehicle. If the borrower defaults on the loan, the lender can foreclose, repossess or otherwise seize the collateral to collect the outstanding loan balance. Since these loans pose less risk to lenders, they are usually characterized by lower interest rates.
Auto loans and home mortgages are common examples of secured loans, but lenders can also make personal loans secured by assets such as a savings account, certificate of deposit, or vehicle.
Unsecured loans, on the other hand, do not require the borrower to pledge any collateral. Here, the lender cannot seize the underlying assets if the borrower defaults. For this reason, interest rates tend to be higher and qualification requirements more stringent. Common examples of unsecured loans include credit cards, student loans and most personal loans.
Revolving loans and term loans
When borrowers get a term loan, they receive a lump sum payment up front and repay it through fixed payments over a period of time. Loan repayment terms typically vary from two to seven years, with longer terms for more creditworthy borrowers. Typically, borrowers have to pay interest on the full loan amount at a fixed or variable rate.
With revolving credit, or revolving credit, the lender grants a line of credit with a fixed borrowing limit. The borrower can access these funds on a revolving basis as needed and only pays interest on the outstanding balance.
When is the right time to get a loan?
A loan may seem like your best option (or the only one), but there are certain circumstances where loans make more sense than alternatives like a credit card or home equity line of credit (HELOC). If possible, avoid taking on new debt unless you have a high credit score and can fit a new loan payment into your budget. If your finances are in shape, consider these situations where a loan might be suitable:
- Home Improvements. Home improvements can range from a few hundred dollars to tens of thousands of dollars. A personal loan or home equity loan can be a great way to fund larger projects, especially if you qualify for a low interest rate. However, if you think your project and expenses will be spaced out over time, consider a HELOC so that you only pay interest on the credit you access.
- High Interest Debt Consolidation. If you have more than one loan or credit card outstanding, a lower interest loan can help you consolidate balances and streamline payments. Using a debt consolidation loan may also lower your overall interest rate and may reduce your monthly payment amount by extending the term of the loan.
- Big purchases. A loan can be an option if you need to make a large purchase and do not have the necessary cash.