How Do Loans Work?

What is a loan?

A loan is an agreement in which a lender provides money to a borrower with the expectation that it will be repaid, typically with interest, over a set period. Loans can be used for many purposes, such as buying a home or car, covering emergency expenses or consolidating debt. They can be offered by banks, credit unions, online lenders and other financial institutions, each with their own terms, interest rates and requirements.

Types of loans

Loans come in many forms, each designed for specific needs and situations. Some common types include:

• Personal loans: Unsecured loans are typically used for purposes such as debt consolidation, home improvements or major purchases.
• Mortgage loans: These secured loans are used to purchase or refinance a home, often with longer repayment terms and lower interest rates compared to other loans.
• Auto loans: Auto loans are secured loans used to buy a vehicle, with the car serving as collateral.
• Student loans: Available through federal programs or private lenders, these loans help finance education-related expenses.
• Home equity loans and lines of credit (HELOCs): Often used for large expenses like renovations, these loans let you borrow against the equity in your home.
• Payday loans: A payday loan is a short-term, high-interest loan intended to cover immediate expenses until the borrower’s next payday, generally considered risky due to high costs.

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.

Revolving credit vs. installment loans

An installment loan, also known as a term loan, allows you to receive a lump sum which you pay off over a set amount of time, usually in equal monthly installments. Revolving credit is a type of flexible loan that lets you borrow money in increments up to a maximum credit limit. Examples of this type of loan include a personal line of credit, HELOC or credit card.

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

Before you fill out an application, take a minute to determine how likely you are to be eligible for the loan product. Start by confirming the lender's requirements for the loan you hope to obtain. You can typically request this information from the lender.

The process of determining your eligibility for a loan is known as underwriting. During this phase of the loan application process, lenders assess a borrower’s creditworthiness and overall financial stability based on several major factors:

• Credit score: 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.
• Debt-to-income ratio: Your debt-to-income ratio (DTI) compares your monthly debt obligations to your income. If you earn enough to cover your loan payment on top of your existing obligations, you may be a good candidate for approval.
• Income and employment: Lenders want to know if you can afford to repay your loan. To make sure you’re not a default risk, you’ll need to submit documentation for income verification. In addition to your salary, the underwriter will look at your income stability and employment history.

From a lender's perspective, it’s wise to limit borrowing amounts and charge higher interest rates when borrowers pose a significant credit risk. However, if your credit history and financial outlook indicate creditworthiness, lenders are more likely to approve a higher loan amount and offer a favorable interest rate.

How to check your credit score

You can usually check your credit score for free through your bank or credit card company. Credit rating agencies such as FICO and VantageScore and credit bureaus such as Experian, Equifax and Transunion also provide free credit checks.

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 prequalification and preapproval

Lenders may be able to provide you with prequalification 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 saves time if your lender requests verification.

Some lenders perform a soft credit check for prequalification. 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, along with information about your employment history, income, existing debts, savings and expenses. For some loans, particularly those that require collateral, you may also need to supply information about your assets.

Next, the lender will begin the underwriting process. After examining your application, they’ll either 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.

5. Accept the loan and receive funding

If your loan is approved, the lender will send an offer outlining the details of your loan agreement, including the loan amount, interest rate, finance charges, repayment date and monthly payment. After you review and accept these terms, you will sign a loan contract and the lender will disburse the funds.

For unsecured personal loans, the loan proceeds are usually deposited to your bank account within a few business days. For a mortgage or auto loan, the disbursement is typically sent directly to the seller.

Loan interest rates and fees

When you take out a loan, the interest rate is the cost you pay to borrow money, expressed as a percentage of the loan amount. Interest rates can be fixed, meaning they stay the same for the life of the loan, or variable, meaning they can change over time based on market conditions. Your credit score, income, loan amount and term length all play a role in determining your rate.

In addition to interest, most loans come with fees that can increase the overall cost of borrowing. Common fees include origination fees (charged for processing the loan), late payment fees and prepayment penalties. Some lenders may also charge application or administrative fees.

It’s important to look at the annual percentage rate (APR) rather than just the interest rate, as the APR reflects both the interest and applicable fees, giving you a clearer picture of the total borrowing cost. Understanding the full scope of rates and fees before you sign a loan agreement helps you budget effectively and avoid surprises later.

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.
• 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 may mean the monthly payment is more affordable to you, but you will pay more interest.

Pay attention to due dates and make sure to submit your payment on time each month. Late payments can negatively impact your credit score and trigger fees.

FAQ

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 (and that you avoid predatory lenders and loan scams). 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.