Learn How Loans Work Before You Borrow

This illustration describes how loans work including "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."

 Britney Willson @ The Balance

Many people use debt to fund purchases they would not otherwise be able to afford, such as a home or a car. 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—with that in mind, no lender wants to lend someone money without the promise of something in return. Keep this 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 back the money within this specific timeframe. Different types of loans have different terms. Credit cards are considered revolving loans, meaning 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 off.

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. Costs are not always advertised upfront when signing for a loan and are usually in financial and legal terminology that can be confusing.

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 either or both the interest rate or term vary then you'll be paying a different amount of total interest.

The costs to a borrower can be very deceiving when rates are taken into account. The annual percentage rate (APR) of a loan is the most popularly advertised by creditors because it doesn't account for compounding interest that is paid over a number of periods.

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

For example, if you are promised an APR of 6% on a $13,000 four-year auto loan with no money down, no other fees, which compounds monthly, 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.

A simple way to calculate your loan interest is to multiply the principal by the interest rate and periods per year for the loan. However, not all loans are designed this way, and you may need to use a calculator for loan amortization or an annual percentage rates 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
Jul 20XX $251.33 $187.26 $64.07 $129.07 $12,626.42
Aug 20XX $251.33 $188.19 $63.13 $192.20 $12,438.22

Fees

You sometimes also 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 rely on loans for interest income. 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 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.

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, no credit, or have filed for bankruptcy.

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.

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