Learn How Loans Work Before You Borrow

An illustration of two hands exchanging money, a person with a bag of money in a thought bubble above their head, a sheet that says monthly payment, a stamp that says approved, two people speaking to each other, and an odometer with a reading that says "you're all good," representing a headline that reads: how loans work, including text: "When you take out a loan, you have to pay back the amount borrowed plus interest (fees may also be included), "To get a loan, you have to qualify," "Do your best to minimize costs and run the numbers to understand before you borrow," "Each monthly payment is split into two parts: a portion of it repays the loan balance, and a portion of it is your interest cost," and "Strong credit helps your chances of getting a loan."

The Balance / Britney Willson

Many people use debt to fund purchases they would not otherwise be able to afford without saving for an extended period. While loans can be great financial tools when they are used properly, they can be great adversaries as well. To keep from taking on too much debt, you should understand how loans work and how money is made for the lenders before you begin borrowing money from eager lenders.

Loans are big business in the financial world. They are used to make money for the lenders. No lender wants to lend someone money without the promise of something in return. Keep that in mind as you research loans for yourself or a business—the way loans are structured can be confusing and cause large amounts of debt.

It's important to know how loans work before you borrow money. With a better understanding of them, you can save money and make better decisions about debt—including when to avoid acquiring more or how to use it to your advantage.

Key Loan Elements

Before you borrow, it's wise to become familiar with some key terms that are associated with all types of loans. These terms are principal, interest rate, and term.

Principal

This is the original amount of money that you're borrowing from a lender—and agree to pay back.

Term

This is the amount of time that the loan lasts. You must pay the money back within this specific timeframe. Different types of loans have different terms. Credit cards are considered revolving loans, so you can borrow and repay as many times as you want without applying for a new loan.

Interest Rate

This is the amount the lender is charging you for borrowing money. It's usually a percentage of the amount of the loan, and is based on the rate the Federal Reserve charges banks to borrow money overnight from each other. This is called the "federal funds rate" and is the rate banks base their own interest rates on.

Several rates are based upon the federal funds rate—such as the prime rate, which is a lower rate reserved for the most creditworthy borrowers, like corporations. Medium and high rates are then given to those with more risk to the lender, such as smaller businesses and consumers with varying credit scores.

Costs Associated With Loans

Understanding any costs associated with a loan can help you figure out which one to choose. Although lenders must disclose all costs, they are usually explained in financial and legal terminology that can be confusing. Here are a few of the most important loan costs to understand.

Interest Costs

When you borrow, you have to pay back the amount you borrowed plus interest, which is usually spread over the term of the loan. You can get a loan for the same principal amount from different lenders, but if the interest rate and/or term vary, you'll be paying a different amount of total interest.

The simplest number to know when it comes to rates is the annual percentage rate (APR). The APR explains how much you'll pay in interest and other relevant fees on an annual basis, and it's helpful for comparing loan costs.

It's best to look for loans with low interest rates and no or minimal fees.

For example, if you have an APR of 6% on a $13,000 four-year auto loan with no money down and no other fees, you'd pay a total of $1,654.66 in interest. Your monthly payments might be higher with a four-year loan, but a five-year auto loan will cost you $2,079.59 in interest.

The easiest way to calculate your loan interest is to use a calculator for loan amortization to determine how much you will end up paying over the term of the loan.

Amortization is the term used for how money is applied to your loan principal and interest balance. You pay a fixed amount every period, but the amount is split differently between principal and interest for each payment, depending on the loan terms. With each payment, your interest costs per payment go down over time.

The amortization table shows an example of how a monthly payment is applied 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 $12,438.22

Fees

You sometimes have to pay fees on loans. The types of fees you might have to pay can vary, depending on the lender. These are some common types of fees:

  • Application fee: Pays for the process of approving a loan
  • Processing fee: Similar to an application fee, this covers costs associated with administering a loan.
  • Origination fee: The cost of securing a loan (most common for mortgages)
  • Annual fee: A yearly flat fee you must pay to the lender (most common for credit cards).
  • Late fee: What the lender charges you for late payments
  • Prepayment fee: The cost of paying a loan off early (most common for home and car loans).

Lenders set their loan terms based on the total interest they'll earn over the life of a loan. When you pay your loan off early, they lose the amount of income for the number of years you will not be paying—the prepayment fee is designed to compensate them for not receiving all the interest income they would have made if you hadn't paid it off.

Not all loans come with these fees, but you should look out for them and ask about them when considering a loan. Note also that some of these fees, such as the application, processing, and origination fees, are included in the disclosed APR. Others, such as late fees or prepayment fees aren't included in the APR since you can avoid them by abiding by your loan agreement.

Watch out for advance-fee loan scams. Legitimate lenders will never require you to pay a fee in order to "guarantee" your loan if you have bad credit or no credit, or if you have filed for bankruptcy. You may need to pay an application fee or credit-reporting fee, but these shouldn't be tied to your credit history.

Qualifying for a Loan

To get a loan you’ll have to qualify. Lenders only make loans when they believe they’ll be repaid. There are a few factors that lenders use to determine whether you are eligible for a loan or not.

Your credit is a key factor in helping you qualify since it shows how you’ve used loans in the past. If you have a higher credit score, then you’re more likely to get a loan at a reasonable interest rate.

You'll likely also need to show that you have enough income to repay the loan. Lenders will often look at your debt-to-income ratio—the amount of money you have borrowed compared to the amount you earn.

If you don’t have strong credit, or if you’re borrowing a lot of money, you may also have to secure the loan with collateral—otherwise known as a secured loan. This allows the lender to take something and sell it if you’re unable to repay the loan. You might even need to have someone with good credit co-sign on the loan, which means they take responsibility to pay it if you can’t.

Applying for a Loan

When you want to borrow money, you visit with a lender—either online or in-person—and apply for a loan. Your bank or credit union is a good place to start. You can also work with specialized lenders such as mortgage brokers and peer-to-peer lending services.

After you provide information about yourself, the lender will evaluate your application and decide whether or not to give you the loan. If you’re approved, the lender will send funds to you or the entity you're paying—if you're buying a house or a car, for example, the money might be sent to you or directly to the seller.

Shortly after receiving the funding, you’ll start to repay the loan on an agreed-upon recurring date (usually once a month), with a pre-determined rate of interest.

In some cases, lenders will restrict how you can use funds. Make sure you're aware of any restrictions on how you use the borrowed money so that you won't get into legal trouble.

Frequently Asked Questions (FAQs)

How do you pay back a loan?

Your loan agreement will have information about how to repay your loan, and the exact setup depends on what type of loan and terms you have. Generally, you'll make a payment by a scheduled due date every month. You can typically set it up as an automatic draft or mail a check to your lender each month. If your loan allows it, you can also make extra payments toward principal to pay it off sooner.

How do I find my monthly payment on a loan?

Your monthly payment amount and due date will be on your loan agreement and in any monthly statements if your lender mails them. You probably can also create an online account with your lender and check your payment information online.

Can I change my loan payment?

As long as your loan doesn't have an early payoff penalty, you can always increase your payment amount to pay off your loan sooner. Keep in mind, though, that paying extra one month may not decrease what you owe the next month. You may still be required to make your normal payment, regardless of any extra amount you paid. Check with your lender for details.

If you want to pay a smaller monthly payment, you'll most likely need to refinance your loan to a smaller amount or longer payoff term.

Article Sources

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  7. Board of Governors of the Federal Reserve System. “What Is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?

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