What Is a Loan?

Understanding loans: the basics

Many of us face numerous big expenses throughout our lives, such as vehicles, education, weddings, new homes, home renovations and costly medical bills. It’s often difficult to pay cash outright for these, but a loan makes it possible to break down a bigger amount into smaller payments that you make over time.

Lenders loan money through either secured or unsecured loans. Secured loans require the borrower to use collateral, or an asset, for guaranteeing the loan. If you don’t pay the loan back, your asset gets repossessed.

An unsecured loan only requires your signature as a guarantee, but it typically has more stringent qualification requirements, such as a higher credit score. It also usually has higher interest rates than a secured loan.

As you go through the loan process, you’ll hear several terms referenced, including:

• Principal: This is the total amount you borrow before any fees or interest.
• Interest: You pay interest to your lender for the convenience of borrowing. This is usually expressed as a percentage of your balance and can vary widely by lender and loan type. A lower interest rate is usually desirable, but a higher-interest loan with a short term length can sometimes cost less in interest than a longer-term loan with a lower interest rate.
• Fees: These are other charges related to your loan, such as origination fees, servicing fees or late fees. Like interest, fees vary by lender and can greatly impact the total you’ll pay on top of the principal.
• Annual percentage rate (APR): Your loan’s APR is a figure that combines interest and fees to give you a better impression of the cost of financing. When comparing loans, it’s a good idea to look at the APR, not just the interest rate or fees.
• Monthly payment: This is the amount you must pay each month on an installment loan. Your monthly payment includes your principal, interest charges and some fees. A lower monthly payment may be more manageable, but a higher monthly payment means you’ll pay off your loan sooner.
• Repayment period: This is the time you have to pay back the loan. Typically, the longer the repayment period, the lower your monthly payments will be and the more interest you’ll owe.
• Prepayment penalty: This is a fee some lenders charge if you pay off a loan early. If you want the freedom to discharge your debt sooner with no extra expense, look for a loan with no prepayment penalties.

How interest works: simple vs. compound interest

The majority of installment loans charge simple interest. This is calculated as a percentage of the principal, or the amount you actually borrow.

Compound interest, on the other hand, is basically interest on interest; it’s interest charged on both the principal and the accumulated interest. Earning compound interest with your savings account is great, but paying compound interest on a debt can be costly.

Loans can also have fixed or variable interest rates. A fixed interest rate stays the same over the life of your loan, but a variable interest rate fluctuates based on market conditions.

Types of loans

There are multiple examples of both secured and unsecured loans, including these common loan types:

• Mortgages: A mortgage is a secured loan used to purchase a property, paid back in monthly installments. Mortgages typically entail a down payment and can have either a fixed or adjustable interest rate.
• Auto loans: This is a secured loan financing the purchase of a new or used vehicle. Similar to a mortgage, an auto loan usually requires a down payment. Most auto loans have fixed interest rates.
• Personal loans: Personal loans can either be secured or unsecured and are often used for covering large expenses or debt consolidation and paid in monthly installments. Interest rates vary considerably based on your credit score.
• Student loans: Typically unsecured, these loans are explicitly for education-related expenses and can come from the government or private lenders. Federal student loans can be subsidized or unsubsidized. Student loans are also available through private lenders.
• Business loans: Business loans can be either secured or unsecured. Borrowers can use these loans for a variety of business-related purposes, such as purchasing equipment, payroll and startup costs.
• Debt consolidation loans: A debt consolidation loan is typically an unsecured loan in which you take out one lump sum to pay off multiple smaller debts. This can aid with budgeting because you only have one payment each month.
• Home equity loans: This is a secured loan that borrows against the equity you’ve built up in your home. Your home is the asset for securing the loan, so default could result in your home being repossessed.
• Credit-builder loans: A credit-builder loan is a secured loan where you make payments to the lender each month, but don’t receive the lump sum “loan” until you’ve completed all payments — the idea is to build credit by making on-time monthly payments that are reported to the credit bureaus, without taking on debt. These loans can be a wise move for borrowers with damaged credit or no credit.
• Subsidized loans: A loan is subsidized if interest accrual is reduced or paused during certain periods. Many federal student loans are subsidized, so no interest accrues while the borrower is enrolled in a qualifying higher education program.

Revolving vs. term

Another loan attribute worth noting is whether it’s a revolving or term loan. When you think of a loan, you’re likely thinking of a term loan. Term loans have a one-time initial payout followed by a set length of time you have to pay it back.

Revolving loans, more commonly called revolving lines of credit, give you the option to take out funds at your discretion, usually up to a maximum credit limit. You’re charged interest on the funds you've withdrawn, and you have to pay back whatever you borrow within the time limit set by your lender.

When should you get a loan?

If your annual income is steady, you have a good or excellent credit score, and you’ve established a positive repayment history with other debts, borrowing may fit into your financial plans. It also helps if a lender has pre-qualified you for borrowing at a lower interest rate.

However, if you can’t qualify for competitive interest rates, you don’t have room in your monthly budget for another financial obligation and/or your income is inconsistent or nonexistent, you should think twice before taking on more debt. If you’re unsure whether you can make at least the minimum payment each month, you should explore other options.

» COMPARE: Best personal loan companies

Pros and cons of getting a loan

There’s quite a bit worth considering before taking on a loan. While a loan can offer a temporary lifeline for your finances, there are disadvantages, too.

Alternatives to loans

A loan may not be your only option when you need additional funds. Consider a few of these common alternatives if you’re unsure whether a loan is right for you.

0% APR purchase or balance transfer credit card

If you have good or excellent credit, you might qualify for a 0% APR credit card for an extended promotional period. You typically need to transfer balances from another card to qualify, which you’ll then repay in full during a short introductory period of 0% interest. Or, if you know you have an upcoming large purchase, you can use the 0% APR for spreading out the purchase payments.

Borrow from friends and family

There may be instances where borrowing from friends and family is possible, which means no credit check or application process, plus you typically get a fair repayment period.

However, this one is tricky because of the relationships involved, so you should only enter into an agreement if you’re confident you can pay back the money as promised without damaging a relationship. You should also put everything in writing so both parties understand the agreement.

Cash advance

You can typically borrow a lump sum against your credit card for deposit into your bank account. This gives you quick access to funds and doesn’t require a separate application. However, doing this uses more of your credit line and is wrought with high fees, so it should be a last resort.

Some cash advance apps will lend you small amounts if you need quick cash before payday rolls around. But be warned, some of these can charge high fees. Read the fine print before taking out an advance.

You should always avoid payday and title loans. These loans offer quick funding, but are so high in fees and predatory lending practices that they are illegal in some states.

» MORE: 11 payday loan alternatives

How to get a loan

You can apply for a loan from a bank, credit union (membership rules may apply) or online lender.

Lenders usually offer pre-qualification with a soft credit check, which means you can see what interest rate, terms and borrowing amount you qualify for without damaging your credit score. Knowing these factors is vital to the comparison process — it’s the bottom line of how much you’re paying for borrowing money.

Once you use a pre-qualification for narrowing down your choice of lender, you can submit a loan application. At this point the lender will conduct a hard credit check. This will impact your credit score by a few points, but as long as you make your payments on time and keep your other debts low, your score will build back up again.

The hard credit check will give your lender insight into your credit activity, including your credit score, current debt, payment history, and any relevant legal or financial actions (such as liens or bankruptcies). Lenders will consider all of these factors, along with your debt-to-income (DTI) ratio, to determine if you’re a trustworthy borrower and can afford your monthly payments.

FAQ

Bottom line

Loans are an important financial tool that can be used for a variety of purposes. If you’re interested in getting a loan, consider your financial situation and make sure you can afford to repay it. Once you’re ready to borrow, shop around for a low rate and good terms — this can save you a lot of money in the long run.