Learn How Loans Work Before You Borrow
When you borrow money, it’s important to know how loans work. With a better understanding of loans, you can save money and make better decisions about debt, including when to avoid it.
The Cost of Money
What does it take to get the money? More money. When you borrow, you have to pay back the amount you borrowed plus interest. You may also have to pay fees.
Costs are a key part of understanding how loans work and which one to choose; in general, it’s best to minimize costs, but costs are not always easy to understand. Lenders don't often show exactly how loans work and what they cost, so it pays to run the numbers yourself.
For most loans, a basic Loan Amortization Calculator will illustrate how things work. If you really want to play with the numbers, use a spreadsheet to see what happens when you change the variables. Costs can be tricky, so be sure to consider interest rates and transaction fees as you study how a loan works.
Paying Down the Loan Balance
It’s only a loan if you repay it. As you figure out how loans work, you’ll see that most loans get paid off gradually over time. 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. An amortization table shows how this works, and how interest costs go down over time.
A loan may or may not have a "term," a length of time over which you repay it. Some mortgages last for 30 years, while other loans may only last three years. Credit cards are "revolving" loans, meaning you can borrow and repay as many times as you want without applying for a new loan. The term affects how your loan works; shorter terms require larger payments.
Qualifying for a Loan
To get a loan you’ll have to qualify. Lenders only make loans when they think they’ll be repaid. Your credit is important in helping you qualify since it shows how you’ve used loans in the past. Good credit means you’re more likely to get a loan at a reasonable rate. You may also need to show that you have enough income to repay the loan.
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. This allows the lender to take something and sell it if you’re unable to repay the loan. You might even have to have somebody with good credit co-sign the loan, which means they’ll promise to repay it if you can’t. Sometimes a well-written letter can help.
How Loans Work in Practice
Now you know more about borrowing in general, but how do loans work in everyday life? When you want to borrow, you visit with a lender and apply for a loan. Your bank or credit union is a good place to start; you can also work with specialized lenders like 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 make the loan. If you’re approved, the lender will send funds to you (or directly to the entity you're paying; someone you’re buying a house from, for example). Shortly after funding, you’ll start to repay the loan, usually monthly.
If you want to save money, you can generally repay loans early. Figure out how your loan works to see if there’s any cost to prepay and make sure it makes sense before doing so.
In some cases, lenders want to restrict how the funds are used. Make sure you are aware of any restrictions on how you use the borrowed money so that you won't get into legal trouble.