Loans: Everything You Need to Know
11 MIN READ
Published April 07, 2023 | Updated February 09, 2024
It's always ideal to save money before you make any large purchases. But that isn’t always possible, especially for expenses such as a home, car, or school. Loans can help you manage these unexpected or large purchases.
Before you apply for a loan, you’ll need to know your options and have a plan for repaying your debt. This guide will provide you with all the information you need about the different types of loans available, how they work, and how you can apply for one.
What Are Loans?
A loan is any amount of money that is lent to a borrower in exchange for repayment of the principal amount. In most cases, the lender will add finance charges and interest to the principal amount that must be repaid.
Loans can be a one-time amount, or they can be available as an open-ended line of credit. They come in different forms, such as secured loans, unsecured loans, personal loans, business loans, and more.
How Do Loans Work?
When someone requires financing, they apply for a loan from a financial institution, bank, or credit union. The application process is usually very straightforward.
Depending on the type of loan you are applying for, you’ll have to provide specific information such as your income details, Social Security Number, and financial history with your loan application.
The lender will then review the information you provided to determine your debt-to-income ratio. This allows them to decide if you’ll be able to repay the loan. Lenders will make a credit inquiry on your credit report before making a decision on the application.
If your loan is approved, you will need to sign a contract that provides the details of the loan, such as the loan term, annual percentage rate (APR), origination fees, prepayment penalty, and loan term.
Once the contract is signed, the lender will disburse the loan amount to your bank account. You will then have to repay the amount along with the interest and any additional charges, typically through a monthly payment.
The loan terms are agreed upon between the two parties before any loan amount can be disbursed. The loan contract will provide details about any collateral needed, the loan interest rate, and the repayment period. Here are a few key terms to know:
The principal is the amount of money you borrow. Usually, the principal is equal to your loan funds. As you continue to make payments, your loan principal will reduce.
This is the amount of time over which you need to repay the loan. The length of your loan will depend on the repayment terms set by the lender and your credit rating. For some loans, such as automobiles, you have more flexibility to determine the number of months you can take to repay the debt. On the other hand, if you're pursuing a personal loan or payday loan, you'll likely be working with short-term loan companies.
Loan repayment is the process of paying back the funds you borrowed. Typically, repayment involves fixed amounts paid on a monthly or quarterly basis. A part of each payment goes to the interest, and the rest will go toward the principal.
A secured loan involves using an asset as collateral. If you don’t repay your loan, the asset can be taken by the lender. Collateral can be your home in the case of a mortgage or your car in the case of an auto loan.
Unsecured loans do not require any collateral. However, they typically come with a higher interest rate because the risk for the lender is higher. Examples of unsecured loans include personal loans and payday loans.
This type of loan allows you to borrow up to a set credit limit, for example, credit cards. At the end of the billing cycle, you can repay the entire amount you borrowed or make a minimum payment and carry over the balance to the next billing cycle.
This is also known as a term loan. This involves making loan payments over a set period of time with fixed payments. Once your pay all your installments, you will no longer owe any debt to your lender.
Fixed Interest Rate
The interest rate remains the same during a set period for debts such as a mortgage or a loan. The interest rate may remain fixed during the entire loan term or for a part of the term.
Variable Interest Rate
The interest rate can change based on the prime rate. When the prime rate increases, the interest rate for your loan can also increase. Variable interest rates can be found in personal loans, credit cards, and mortgages.
How To Be Eligible for a Loan
You’ll need to demonstrate your creditworthiness to qualify for a loan and get competitive rates. There are many factors that lenders consider when determining their risk:
Your credit history and FICO score are based on your history of repayment. Bankruptcies, missed payments, and late fees can lower your score and make it more difficult to qualify for a loan. Those with excellent credit usually qualify for a lower rate.
For certain loans, especially for larger amounts, lenders may have an income threshold. You will need to have several years of employment to qualify for mortgages to ensure that you won’t have trouble repaying. You can also use a cosigner to qualify for mortgages.
Loan providers also look at your debt-to-income ratio (DTI) to determine how much you earn and how much debt you currently have. A high DTI ratio indicates that you may have difficulty repaying your debts. Lower your DTI ratio to get loan offers with the lowest rates possible.
To be eligible for a loan, you’ll have to show lenders that you can use credit responsibly. Avoid taking out unnecessary loans and pay off your credit cards and loans regularly. Good credit will also allow you to get lower interest rates.
Loans for bad credit are available if you have poor credit or a lot of debt. These loans usually come with a high-interest rate and can be more expensive for you in the long run.
6 Types of Loans You Should Know About
Here are some of the most common loan options available, along with their key features:
1. Personal Loans
Personal loans can be used for any purpose. These loans are usually unsecured, so you do not need to provide collateral. Personal loans may have variable or fixed interest rates and repayment terms of six months to a few years. The funds can be used for things like home improvement, weddings, or emergency expenses.
2. Auto Loans
If you are planning to purchase a car, an auto loan will allow you to borrow the price of the vehicle after deducting the down payment. An auto loan is secured, so your car will be collateral. This means that if you fail to make payments, your car can get repossessed. Auto loans are available from 36 months to much longer, depending on the price of the vehicle.
3. Student Loans
Student loans are offered by private lenders and the federal government to cover the costs of undergraduate and graduate education. When you accumulate federal student loan debt from the U.S. Department of Education, they will offer income-based repayment options, forbearance, deferment, and other features.
Federal student loans are offered through schools as financial aid. The loan terms, interest rates, and repayment periods are the same for all students.
With a private loan, the terms, fees, and interest rates will vary. If you do not qualify for federal student loans, a private lender loan may be your next best option.
4. Mortgage Loans
Mortgage loans provide funds to cover the purchase price of a home minus the down payment. Your house will act as collateral, and if you fail to make mortgage payments, it can be foreclosed on by your lender.
Mortgages usually carry a term of 10 to 30 years. Some borrowers may qualify for mortgage loans backed by agencies like the Veterans Administration (VA) or the Federal Housing Administration (FHA) which offer assistance in setting up an affordable payment structure.
Conventional mortgages are loans that are not insured by government agencies. Mortgages may carry a fixed interest rate that remains the same throughout the term or an adjustable interest rate that changes annually.
5. Debt Consolidation Loans
Debt consolidation loans are a type of personal loan that is offered to pay off your high-interest debt. These loans are usually available at a lower interest rate when compared to credit cards.
They can help you save money and simplify repayment because they allow you to consolidate multiple debts into a single loan. Paying off your high-interest credit card debt with a debt consolidation loan can also improve your credit utilization ratio and your credit score.
6. Business Loans
There are several different types of business loans available such as equipment loans, term loans, working capital loans, and Small Business Administration (SBA) loans. These loans are designed to fund the operations of small businesses.
When compared to personal loans, the qualifying criteria for business loans can be more stringent, especially when you apply for an SBA loan. However, compared to other financial options, such as cash advances, business loans are more affordable. They can also provide you with the financing you need to grow your business.
It’s also important to note that when applying for a business loan it doesn't necessarily mean it's only tied to the business EIN. Typically, most lenders will ask for a personal guarantee in order to get the business loan. This means if you default on the business loan they can come after you personally. Thus, ensure you fully understand the terms of a business loan before committing to one.
Loans Vs. Credit Cards
Loans offer borrowers funds in a lump sum. The amount you borrow must be repaid within a determined amount of time, with payments that are typically fixed.
Loans are usually available at a lower interest rate when compared to credit cards. They can be unsecured or secured.
Credit cards are revolving, which means that they give you access to funds when you need them up to a predetermined limit. They are unsecured and usually carry a higher interest rate.
Loans Vs. Debt
A loan is a type of debt, but it is an agreement between two parties where one party lends funds to another. The repayment terms, interest rate, and when the money needs to be repaid are set by the lender.
Debt can involve anything you borrow, such as money, property, or service. It can be a loan, credit card, mortgage, or line of credit.
Regardless of the type of loan you borrow, it is important to have a plan to repay the loan. If you are overwhelmed with a lot of debt, debt relief is available to help you repay your outstanding balances faster.
TurboDebt can help you take your first step toward a debt-free life. Our knowledgeable debt relief professionals can provide consultations, counseling, and strategic planning services to help you find the right debt solution for your financial situation.