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How do loans work?

Understanding loans ensures better financing choices in your future

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Written by Sandy Baker
Edited by Justin Martino
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Loans are one of the most important financial tools available today and a large part of most Americans' lifestyles. Borrowing money to fund goals and needs often makes sense, especially if you know you can afford the monthly payments.

Loans can be complex, with numerous options and a lot of fine print. It’s not always simple to know which one is the best for your needs. The more you know, though, the better decision you can make when applying.


Key takeaways

  • Loans are either secured — meaning they require collateral the lender can seize if you default — or unsecured.
  • Having good credit is the key to unlocking better rates and lowering the cost to borrow.
  • It’s essential to make your loan payments on time to avoid negative credit marks and fees.

How do you apply for a loan?

Applying for a loan seems easy enough, but it requires several steps. If you are applying for a personal loan, take these four steps.

1. Consider your eligibility

While you may be ready to fill out an application, take a minute to determine how likely you are to be eligible for the loan product. Credit history is a significant part of this.

If you have a good credit score, you may pay a lower annual percentage rate (APR) on the loan, which saves you money. Having bad credit may mean it's more difficult to obtain the loan or that you’ll pay a higher APR.

If you haven’t done so yet, check your credit score. If you have an existing credit card, your credit card company may provide you with an up-to-date FICO score.

Then, determine what the lender’s requirements are for credit scores for the loan you hope to obtain. You can typically request this information from the lender.

2. Compare lenders and fees

Before applying, learn as much as you can about the lenders’ offers. This includes the interest rate, APR, borrowing limits and terms. Be sure to compare how much your monthly payment will be and the cost of any additional fees between lenders.

3. Consider pre-qualification and preapproval

Lenders may be able to provide you with pre-qualification for a loan based on the information you provide in your application. Preapproval doesn’t occur until the lender verifies all your financial information. That usually includes income and expenses.

Collecting all the necessary documents before applying for a loan helps ensure you provide accurate information and saves time if your lender requests verification.

Some lenders perform a soft credit check for pre-qualification. That means they can tell you if you qualify for the loan before you actually apply for it formally. A soft credit check doesn’t impact your credit score like a hard inquiry does; preapproval generally requires a hard credit inquiry.

4. Apply and wait for approval

Be sure to understand the application requirements. Most often, you’ll need to submit your name, birthdate, Social Security number and address to the lender. Most lenders also ask how much you wish to borrow and how you plan to use those funds. You’ll need to provide information about your income and expenses each month to determine if you qualify.

Once you apply, the lender will give an approval decision or request additional information. This may happen right away, but it can also take several days. Once you receive approval, ask how the lender will transfer the money to you.

Secured vs. unsecured loans

When choosing a personal loan, you may find options for both secured and unsecured loans. A secured loan is one that requires some type of asset as collateral the lender can seize if you default on your loan. For example, you may be able to take out a secured personal loan that uses jewelry as collateral.

An unsecured loan does not have any type of collateral. That makes it more of a risk to lenders. These loans are often only available to those with good or excellent credit and, in some cases, may come with a higher interest rate.

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    How do loan payments work?

    Be sure to review all aspects of the process when comparing loan offers, including what you can expect from the payment process. Some things to consider include:

    • Term length: Determine the loan term (how long you have to repay the loan) as a first step. Shorter terms require you to pay less in interest over the life of the loan, but they come with larger payments.
    • Fixed payments: Many personal loans require a fixed payment throughout the lifetime of the loan, which means you’ll pay the same amount each month. Others have variable interest rates and payments. Know what to expect based on the loan terms.
    • Due dates: Often, the loan documentation includes which day of the month the loan payment is due. Don’t miss that payment deadline, and try to pay at least a few days in advance.
    • Prepayment penalties: Some loans do not let you repay faster than outlined in the loan contract without paying a fee. Many other loans allow you to pay off your loan early without penalty.

    Also, consider the amortization schedule. This shows how your loan payments apply toward principal and interest over time. Often, at the start of the loan period, most of each payment goes toward interest. The principal, which is the original amount you borrow, is paid down in a smaller amount at first.

    Over time, more of your monthly payment goes toward principal and less toward interest. You can ask for the amortization schedule for your loan so you can see how much of your payment applies to principal and interest ahead of time. Paying more than normal and applying that extra payment to the principal may help save you money over time.

    How do you pay back a loan?

    Paying back a personal loan requires you to understand the loan terms you've agreed to. When selecting a loan, be sure to weigh the pros and cons of different types of loans.

    For example, a short-term loan is likely to have higher monthly payments, but you’ll pay it off sooner, which means a lower overall cost due to paying less interest.

    A longer loan may also be an option. Extending the loan a bit longer may mean the monthly payment is more affordable to you, but you will pay more interest.

    Be sure to pay back your loan on time each month to prevent any negative impact on your credit score and avoid fees that can increase the overall cost of your loan.

    Bottom line

    Taking out a loan may help you meet your financial goals. You could use it to consolidate high-interest debt, remodel your home, buy a car, pay for an emergency expense or a host of other purposes.

    What's most important is ensuring you get the right loan. Carefully consider several lenders to determine which can offer you the best terms and interest rates. It also helps to have information about lenders’ eligibility requirements, including the credit scores they accept.

    If possible, work on polishing your credit history so you can present the best possible credit score to lenders. That way, you’re likely to receive a lower interest rate and more favorable loan terms overall.

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