What Loans Are and How They Work
Key Features and Definitions of Loans
A loan is an arrangement where you receive money now and repay the funds later, either over time or in a lump sum. To compensate the lender that provides the money, you typically pay back more than you receive. That compensation might consist of upfront finance charges at the time you borrow or interest and other fees over time.
Loans allow you to spend money you need now and repay in the future.
Borrowing is one of the most important tools in your financial toolkit. Loans can open doors for you (like owning a house or getting an education, for example), but they can also cause problems. That’s why it’s crucial to understand how loans work from the bottom up.
How Loans Work
When you need money, you ask a lender to provide funds. To do so, you typically submit a request or “apply” for a loan, and the lender decides whether or not to approve your application. Lenders make their decision based on your creditworthiness—their evaluation of whether or not you will repay the loan.
The Price of Money
In exchange for receiving money from somebody else, you often pay back more than you borrow. With most loans, you pay a percentage of the amount you borrow as interest. You might also have to pay other charges, like loan origination fees, finance charges, or other costs.
Types of Loans
Loans come in a variety of forms, but most loans fall into broad categories: installment loans and revolving loans.
- Installment loans are one-time loans that provide funds to a borrower up front. You pay off an installment loan over time, often with fixed monthly payments. A portion of each payment goes toward your interest cost, and the rest of the payment reduces your loan balance. These loans may be known as amortizing loans. Common examples include home purchase loans, auto loans, personal loans, and many student loans.
- Revolving loans allow you to borrow and repay repeatedly. Instead of receiving funds up front, you have the ability to spend from a line of credit, up to a maximum limit. Repayment requirements depend on the specifics of your loan. Examples of revolving debt include credit cards and home equity lines of credit (HELOCs).
Loans can be further classified by whether they are secured or unsecured.
- Secured loans require collateral to “secure” your debt. If you don’t repay the loan, lenders can take the collateral and sell it in hopes of collecting your remaining loan balance. For example, if you don’t repay a home loan, lenders might foreclose on your home, forcing you to find new housing and causing damage to your credit.
- Unsecured loans do not require collateral. Lenders approve those loans based on your creditworthiness, and there’s no specific asset for them to seize. But if you don’t repay, lenders can report the missing payments to credit bureaus, making it harder for you to borrow in the future, and take additional action to collect what you owe.
When borrowing money, take note of how you pay interest so you can minimize costs and prevent debt from spiraling out of control.
Amortizing loans like fixed-rate mortgages charge simple interest on your loan balance. As a result, your interest charges tend to decrease over time because you’re paying down your loan balance.
With other loans, including credit cards, your lender might add interest charges to your loan balance. If you don’t pay enough to cover the interest costs, your loan balance can increase over time, and you pay interest on those new interest charges each month. In other words, you pay interest on money you never spent.
Your interest rate is an important factor when you borrow, and low rates make borrowing more affordable. With installment loans, the interest rate affects your monthly payment (impacting your cash flow every month until you pay off the debt). Because of that, it’s smart to improve your creditworthiness so you qualify for the lowest rates possible.
What to Watch Out For
A loan is a powerful financial tool, but you should be aware of a couple of things.
With some loans, your interest rate can change over time. For example, adjustable rate mortgage (ARM) rates can rise or fall periodically. If rates rise, your required monthly payment increases as well—which can be an unwelcome surprise. Fixed-rate loans do not have adjustment features, so they are more predictable.
Focusing on the Payment
Your monthly payment affects your cash flow, but it shouldn’t be the driving factor behind your decisions. You can obtain a low monthly payment in several ways. For example, you can stretch out payments over an extended period, choosing a 30-year mortgage instead of a 15-year loan. But the longer you borrow, the more interest you pay—so it might be best to opt for a higher payment.
Getting Tied Down
Access to cash is great, but loans can severely limit your freedom and lead to trouble. With burdensome loan payments, it’s harder to move or change jobs, and you have less income available if you need to apply for a new loan.
Minimize your borrowing whenever possible by making a substantial down payment and spending only as much as you need.