What is a loan?

Understanding loans: the basics

There are numerous big expenses many of us face throughout our lives, such as vehicles, education, weddings, new homes, home renovations, costly medical bills and more. It’s hard for someone to pay cash outright for these, but a loan makes it possible to break down a bigger amount into smaller payments.

Lenders loan money through either secured or unsecured loans. A secured option means you must 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.

As you’re going through the loan process, there are several terms you’ll hear referenced, including:

• Principal: The total amount you borrow
• Interest: What you pay your lender for the convenience of borrowing, usually expressed as a percentage of your balance
• Fees: Other charges related to your loan, like origination fees or late fees
• Annual percentage rate (APR): A figure that combines interest and fees to give you a better impression of the cost of financing
• Monthly payment: The amount you must pay each month on an installment loan
• Repayment period: The time you have to pay back the loan

Types of loans

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

• Mortgages: A secured loan used for purchasing a property paid back in monthly installments, with either a fixed or adjustable interest rate
• Auto loans: A secured loan financing the purchase of a new or used vehicle, similar to a mortgage
• Personal loans: Can either be secured or unsecured and are often used for covering large expenses or debt consolidation and paid in monthly installments
• Student loans: Explicitly for education-related expenses and typically unsecured
• Business loans: Come in either secured or unsecured options and used for a variety of business-related purposes, such as purchasing equipment, payroll and startup costs
• Debt consolidation loans: Typically an unsecured loan in which you take out one lump sum to pay off multiple smaller debts, so you only have one payment each month
• Home equity loans: A secured loan that borrows against the equity you’ve built up in your home; you use your home as the asset for securing the loan
• Credit-builder loans: 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, but without taking on debt

Revolving vs. term

Another loan attribute worth noting is if it’s a revolving versus a 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 have established a positive repayment history with other debts, then borrowing may fit into your financial plans. It also helps if a lender has pre-qualified you for borrowing at a lower interest rate.

“A consumer should consider getting a loan when they have a significant financial need that their current income or savings cannot cover, such as buying a house, a car or funding a big-ticket purchase,” said James Allen, a certified financial planner and the founder of Billpin, a personal finance website.

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, then you should think twice before taking on more debt.

“Taking on a loan should be like putting on a heavy backpack — you need to be sure you have the strength to carry it,” said Allen. “The biggest consideration is your ability to repay the loan. You need to calculate your debt-to-income ratio and ensure you have enough income to comfortably handle the repayments. If your backpack is too heavy, it might be time to lighten the load or reconsider your journey.”

» 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 if 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 only enter into an agreement if you’re confident you can pay it back as promised without damaging a relationship. Also, one suggestion is to 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, which is why it should be a last resort.

There are also some cash advance apps that 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.

Finally, a word of caution: 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, 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. Note that this will impact your credit score by a few points, but so long as you make your payments on time and keep your other debts low, your score will build back up again.

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.