What is a loan?

In simple terms, a loan is a contractual agreement between a borrower and a lender where the lender agrees to give the borrower a sum of money in exchange for repayment. Loans generally have to be repaid with interest, which is how lenders make money. Loans may or may not be secured by collateral, and funds may be provided in a lump sum for a set length of time or made available through an open line of credit.

Key insights

• Your loan principal is the amount you borrow, and interest and fees are what you pay to borrow that money.
• Your loan agreement should stipulate how you're supposed to repay your loan and what it will cost you overall.
• Make sure you can afford to repay whatever you borrow — missing a payment can drop your credit score by as much as 110 points, according to LendingTree.

How loans work

With car and home prices increasing, many people are looking to make big purchases sooner rather than later. Most people can’t afford to buy these things outright, though. That’s where a loan comes in.

When you take out a loan, you’re borrowing money from a lender, generally under the agreement that you'll pay back what you borrowed plus some extra. Because you can repay your lender over time, a loan allows you to buy things now that you’d otherwise have to save up for.

It’s important to learn some basic loan terminology if you want to understand more about how loans work:

• The principal is the total amount you borrow.
• Interest is what you pay your lender for the convenience of borrowing, usually expressed as a percentage of your balance.
• Fees are other charges related to your loan, like origination fees or late fees.
• Your annual percentage rate (APR) is a figure that combines interest and fees to give you a better impression of the cost of financing.
• Your monthly payment is the amount you must pay each month on an installment loan.
• Your repayment period is the time you have to pay back the loan.

Most loans are structured so that you'll make consistent recurring payments that cover a portion of the principal and interest until your debt is gone. With each payment you make, you pay off more of the principal. This, in turn, decreases the interest you have to pay (since it's calculated as a percentage of the principal). The reason your payments stay the same is that amortized loans balance out the proportions of principal and interest you pay throughout the life of the loan.

Just be aware that some loans have different payment schedules and terms, so check your loan agreement to see what you’re signing up for.

Types of loans

There are many types of loans available for borrowers, and lenders are able to set their own rates and terms, so it pays to shop around to see what’s right for you.

Many lenders now offer online application and disbursement processes, which a reviewer from Arizona on our site said made getting a loan particularly convenient. "Online was really, really nice. This was my ninth or 10th home I’ve purchased in my old age, and this was the easiest one, because they were so clear and concise," they told us in an interview.

Loan rates and terms vary by loan and by lender, so if you're looking for a loan, it definitely pays to shop around.

As loans become easier to obtain, it’s important for borrowers to understand the different types available. Loan options include everything from payday loans, which should be paid off with your next paycheck, to home loans that can take decades to repay. Some of the most common types of loans are:

• Mortgages
• Auto loans
• Personal loans
• Student loans
• Business loans
• Debt consolidation loans
• Home equity loans
• Credit-builder loans

Loans are generally defined by their purpose, but they can also be categorized depending on whether they’re secured and if they’re revolving or term loans.

Secured vs. unsecured

Secured loans are backed by collateral. Examples of secured loans include auto loans and home loans. If you default on this type of loan, the bank will seize the asset you used for collateral as a form of repayment. However, these loans usually have better rates because they’re backed by a tangible asset.

Unsecured loans aren’t backed by anything other than good faith. They generally require a more stringent approval process because the lender has less recourse if you default on your payments. Common types of unsecured loans include student loans and personal loans.

Revolving vs. term

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. Just know that you’ll generally be charged interest on the funds you've withdrawn, and you’ll have to pay back whatever you borrow within the time limit set by your lender.

Understanding interest rates

Interest is the amount a lender charges for the service of lending you money, and it’s usually calculated as a percentage of the principal you’re borrowing. Interest rates on loans vary from loan to loan and from lender to lender. Generally, the better your credit score, the lower the interest rate.

Lenders use your credit score and other factors to determine your risk level and the interest rate they'll charge you. If you have a history of paying back your debts on time, you can expect a lower interest rate. However, if you’re unproven or you have a poor credit history, you should expect a higher interest rate.

Why interest rates are important

The interest rate on a loan reflects how much you’re paying to borrow that money, and small changes in your interest rate can have a big impact on your overall cost. All else being equal, a loan with a lower interest rate will cost you less to pay back and can save you a significant amount of money in the long run.

However, loan terms are rarely identical. For example, a loan’s repayment term can also affect the amount you end up paying over time, according to Andrew Orozco, mortgage loan originator at Island Pacific Mortgage in Hawaii. “I recently helped a homeowner refinance his previous 30-year term mortgage to a 15-year term,” he said. “Although his interest rate was only 0.5% lower than his previous loan, the shorter term will amount to a heart-stopping $220,000 in total interest savings over the life of this shorter loan.”

“With shorter terms, the payments are typically a bit higher,” he added. “But the difference is that a significantly higher proportion of each payment goes towards the principal (or remaining balance) rather than the interest.”

Why banks give loans

Banks and other lenders offer loans because they make money off of interest and fees. Imagine you took out a 30-year mortgage for $200,000 at a 5.27% interest rate. Over the next three decades, you’d pay back almost $400,000 total. That means you’d spend nearly as much on interest as you did on principal.

Lenders make a lot of money one interest, which is one reason they work so hard to evaluate borrowers before they give out loans. If a borrower defaults, the lender can lose out on both the principal amount they provided and the potential profit they would have made. This is also why riskier borrowers generally get higher interest rates — if a lender is going to take on greater risk, they’ll usually want to see higher potential profits in return.

What happens if you don’t pay it back?

Failing to pay back a loan, also known as defaulting on a loan, can be detrimental to your financial future. As you miss payments, your balance due will build up, and you can be charged a host of penalties and fees. Eventually, the lender may garnish your wages or send your bill to a collections agency. If the loan is secured, your lender will likely repossess your collateral.

Defaulting will also cause your credit score to fall, which can make it harder (and more expensive) to take out additional loans in the future. According to LendingTree, one late payment can drop your credit score by as much as 110 points. Defaulting on a loan can stay on your credit report for up to seven years.

Lenders generally don’t want you to default. Even if your loan is secured, repossession and foreclosure aren’t cost-effective, so lenders will often make more money when you’re paying them interest. Because of this, many lenders offer grace periods and assistance programs to help if you miss a few payments.

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.