How Do Loans Work?

money exchanging hands as a loan is agreed upon

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Regardless of why you want to take out a loan, it helps to know how loans work. With so many different loans that exist for different reasons, knowing more about loans will help you choose one that’s right for your situation.

While household debt hit $14.6 trillion in 2021, according to Debt.org, debt can still be beneficial when used correctly.

In this article, we’ll discuss what loans are, how they work, and what to look for in a loan.

Let’s jump in.

What is a Loan?

A loan is money borrowed that is expected to be paid back with interest. 

More specifically, a loan involves a lender lending money to a borrower where the borrower agrees to pay the money back under specific conditions. Borrowers are legally bound to repay a loan once a loan contract is signed.

Secured loans are backed by collateral, such as an automobile or house. Because of this, secured loans are seen as less risky to lenders. 

Unsecured loans do not have collateral backing them, making an unsecured loan riskier for a lender.

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How Does a Loan Work?

A loan has an amount lent to the borrower, an interest rate, and a term length to pay it back. 

For example, a personal loan for $10,000 might have a repayment period of 5 years with a 9% interest rate. 

The monthly payment would be $198.01, and the borrower would pay $1,880.72 in interest over the course of the loan, assuming the loan is paid each month on time with no prepayments.

Having a good credit score helps you get more favorable loans at more favorable interest rates, as lenders will see you as someone who will be more likely to pay back your loan as agreed upon.

How Does Your Credit Score Work Affect Your Loan?

Your credit score is an indicator of your creditworthiness, and lenders use this score to determine if they’ll lend you money, what types of loans they’ll offer you, and what interest rates and fees will be on the loan.

The higher your credit score, the better offers you’ll get on a loan. 

Checking your credit reports with the three major credit reporting bureaus – Equifax, Experian, and Transunion – at AnnualCreditReport.com will allow you to identify any errors or issues that may be reducing your credit score. Taking care of any errors on your report before you apply for a loan can help you get better loan terms.

If you have a low credit score, you may consider building it up before taking on a loan. 

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How Does Loan Interest Rate Work?

The loan’s interest rate is the amount a lender charges a borrower for lending them the money and is a percentage of the principal amount that is loaned. Interest is typically denoted as an annual percentage rate or APR.

Interest is calculated in a number of ways, depending on the loan. Here are typical ways that interest can be calculated.

Fixed Rate

A fixed interest rate means you pay the same rate for the lifetime of the loan. This means your loan payment won’t change, which makes it easier to know what your payment will be each month.

Loans are commonly fixed rate, but variable rate loans also exist.

Variable or Adjustable Rate

Variable or adjustable rates can increase or decrease over time. This means that you may pay a different monthly payment over the course of the loan as rates change. 

Typically, adjustable rate loans have a lower starting interest, but the borrower has the risk that interest rates will rise while they’re paying off the loan, which will cause their monthly payment to increase.

Simple Interest

Simple interest is relatively straightforward. For example, if you borrow $5,000 with a 10% interest rate, and the loan’s interest is calculated with simple interest, then you would multiply $5,000 by 10% to get $500, which would be the total interest owed over the loan.

From there, you’d see that you’d owe and pay a total of $5,500 by the end of the loan.

Compound Interest

Compound interest is typical when using credit cards, which are a type of unsecured loan. For example, if you have a $5,000 balance on your credit card and your credit card has a 20% interest rate, then at the end of year one, assuming you never paid down your balance, you would owe $6,000 since $1,000 is 20% of $5,000.

At the end of year 2, you would then owe $7,200 because you would calculate 20% interest on the $6,000 balance, not on the original $5,000 balance.

Because of how credit cards can have high interest rates and how compound interest works, one can spiral into debt quickly when credit cards are used too often and not paid down as soon as possible.

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Amortized Interest

Amortized loans are typical with mortgages, and they’re designed in a way that the borrower pays a larger amount of interest towards the beginning of the loan and less interest towards the end. 

As the loan is paid each month, more money goes towards the principal, and less money goes towards interest, though the monthly payment remains the same.

What Makes Up a Loan?

There are several parts of a loan that make it up. Knowing the different aspects of a loan will help you compare multiple loans side by side.

Principal

The principal is how much money you initially borrow when you take out a loan. Your principal balance is how much you owe, and your loan is paid off when it reaches zero.

Interest Rate

The loan’s interest rate is the amount a lender charges a borrower for lending them the money and is a percentage of the principal amount that is loaned. Interest is typically denoted as an annual percentage rate or APR.

Loan Repayment Term

The loan repayment term is the amount of time you have to repay the loan. For example, you might have a 30-year mortgage or a 5-year auto loan.

Shorter loans generally mean you’ll pay less interest, while longer loans generally mean a lower monthly payment. This is something to consider when you have a choice in repayment term.

Paying a loan monthly is typical, though some loans may be more frequent.

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Collateral

A secured loan is backed by collateral which is an asset that the lender can take from you to cover their losses if you don’t repay them.

On the other hand, there is no collateral for an unsecured loan, however, if you don’t pay off your debt, your lender can send the debt to a collections agency, which can lower your credit score. A lender may also be able to sue you if you don’t pay back your loan.

Origination Fees

Origination fees may be charged when you take out a loan. An origination fee is an upfront fee charged by the lender to process a new loan application.

Down Payment

For some loans, you may need to make a down payment to show that you’ve got “skin in the game.” This is typical for home loans and auto loans.

The amount that is required for a down payment will depend on the lender and your creditworthiness, but house down payments are typically 3.5% to 20%, while auto loans are typically 10% to 20%.

That said, it’s also possible to qualify for loans without any down payment.

Additional Fees

Some loans come with additional fees, such as for administrative reasons. You may have to pay these fees to your lender or third parties.

Sometimes these fees can be rolled into your loan, and other times they’ll have to be paid upfront.

Different Types of Loans

While many types of loans exist, here are the most common ones that you’ll encounter.

Personal Loan

A personal loan is money borrowed for a wide array of things. Personal loans can be used for anything from debt consolidation to credit card payoff, wedding planning, and much more.

Personal loans can be unsecured or secured and you can get your money relatively quickly once approved. 

Banks, credit unions, and peer-to-peer lending companies are all places where you can get a personal loan.

Because personal loans can be used for a wide array of things, and that they can come secured or unsecured, interest rates vary greatly, and it’s possible your loan could have double-digit interest rates, especially if you don’t have good credit.

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Business Loan

Business loans are used to fund a new or existing business. This money can be used for hiring staff, buying equipment or inventory, for working capital, and similar.

Student Loan

Student loans are used to pay for higher education. You can apply for federal student loans or private student loans (or both, sometimes). Different student loans exist for different situations.

Federal student loans come in subsidized and unsubsidized forms. Subsidized loans do not accrue interest while you’re enrolled at least half-time in school.

Private student loans typically have higher interest rates and are offered through banks and online lenders.

Before taking on student loans, be sure you understand how much you’re taking out and what the terms are. Many people with student loans have struggled to repay their debt.

Auto Loan

Auto loans are used to purchase automobiles such as cars and trucks. You’ll typically have the option to finance an auto purchase through the dealership, though getting a loan from a bank or credit union may yield you a loan with a lower interest rate.

One trick is to talk to lenders before going to an auto dealer and see what type of auto loans you qualify for before you even enter the dealership. That way, you can get the best interest rate and loan terms when you buy your car.

Home Loan

A home loan, or mortgage, is money you use to buy a home. There are many available types of home loans, including FHA loans, VA loans, 30-year loans, 15-year loans, and more.

Interest rates with mortgages vary based on the type that you get. With home loans, the home you buy is typically the collateral you put up for the loan.

Payday Loan

A payday loan is a relatively small amount of money that is lent at a very high interest rate, often three-digit interest, that is agreed to be paid back when the borrower receives their next paycheck.

In general, it’s best to avoid payday loans as the high fees, and short repayment terms can trap you in a cycle of debt. 

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The Loan Process

Some loans require more paperwork and involvement than others. With that in mind, here is the basic process that is typical of most loans.

Apply

Before you can get a loan, you’ll first need to fill out an application. Loan applications ask for personal information, including things such as:

  • Your full legal name
  • Date of birth
  • Social Security number
  • Address
  • Phone number
  • Email address

You’ll also need to supply information such as how long you’ve been at your job and the amount of your household income. Other information typically included in a loan application is your assets owned and any liabilities (money owed) you have.

Qualify

After you submit your application, the application is sent to underwriting to determine if it will be approved. Most of the time, lenders now check your credit report and credit score. 

Using information from your application and in your credit profile, the lender will come up with a loan amount, interest rate, and other terms for the loan.

Disbursement

If you qualify for the loan, then funds will be disbursed to you in most cases. For mortgages, a title company typically holds the money.

Some lenders take longer than others to disburse funds. It’s sometimes possible to receive your money in as soon as 24 hours.

The money becomes a debt once you receive it.

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Pay Back the Money

Once you have the money, you’ll start paying back the principal, generally every month. Some of your payment will be applied towards the principal, while some will be applied towards interest. 

Things to Look For In a Loan

Here are some things to consider when you go to take out a loan.

Loan Use

Consider what you’re taking the loan out for. Is what you’re getting money for going to help you in the future? 

For example, if you take a loan out to finance an education, that education can help you earn more money in the future.

On the other hand, financing a $1,000 wardrobe to look good when you go out might hurt your wallet long term.

Loan Interest Rate

Comparing interest rates makes sense as it can help you save money. While it generally makes sense to go with a loan with a lower interest rate, it’s important to see if the lower interest rate loan could have its rate rise at some point, such as if it’s a variable interest rate loan. 

While fixed interest rate loans may have a higher rate, the monthly payment on your loan will be predictable throughout the entire term.

Loan Term Length

The term of your loan is how much time you have to pay it off. 

Personal loans typically range from two to five years. The standard repayment of a student loan is ten years, and most mortgages are repaid in 30 years.

Loans can typically be paid off early, which can be advantageous if your interest isn’t precomputed, as you’ll pay less interest for paying your loan early.

That said, the interest you pay on student loans, and mortgages can often be tax deductible, which you may prefer instead of paying off your loans sooner.

How Much is the Monthly Payment

Looking at a loan's monthly payment can help determine if you can afford it.  You’ll also want to consider the loan term length and think ahead.

For example, if your loan is for five years and you’re paying $300 per month for five years, will you be able to afford $300 per month for the next five years?

Consider where you might be down the road with your career, family, and potential changes that might come up.

All of this can help you determine if you can afford the monthly payment for the life of the loan.

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Check your rate in minutes without affecting your credit score.

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Is the Lender Well Rated?

Research a lender before you borrow from them. Lenders should be easy to communicate with, and their loan terms should be easy to understand and make sense to you.

How Soon Do You Have To Start Paying Back a Loan?

For most loans, you’ll start paying them back 30 days after the money is disbursed to you. For student loans, it’s typical to start paying them back six months after you graduate, fall below half-time enrollment, or leave school.

Do Loans Hurt Your Credit Score?

Taking out a loan affects your credit score. To help your credit score, pay your loan on time each month. A late or missed payment can significantly hurt your score.

Is Prepaying Your Loan Better in the Long Run?

If your loan has a higher interest rate than your investment returns, then prepaying your loan may be the better choice long term.

How Can I Raise My Credit Score Before Applying for a Loan?

To raise your credit score before applying for a loan, employ some of the following:

  • Make all of your monthly debt payments on time
  • Don’t open too many lines of credit at once
  • Keep your credit utilization low
  • Find errors on your credit report and dispute them

Using these methods can help you get better loan terms and lower interest rates.

Wrapping It Up

In this article, we discussed what a loan is and how loans work. Loans can be a helpful tool when you want to further your education, buy a new house, or fund a business.

That said, loans also mean taking on more debt. Be sure to consider why you want to take out a loan and if what you’re borrowing the money for will benefit you long term or simply in the moment.

Are you looking for a personal loan? Check your rate in minutes at Upstart.

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