How Do Loans Work?
Americans and the word debt often seem like they go hand-in-hand. And for good reason.
U.S. household debt hit an astonishing — and record-breaking — $14.6 trillion in 2021, according to Debt.org. Granted, this high total was partially influenced by the pandemic. And this figure is total debt, which includes non-loan amounts like money owed on credit cards.
But, if used wisely, debt can be a tool. Contrary to the opinion of some personal finance gurus, debt — and specifically speaking, loans — can help you pay for a four-year education or buy a home. Loans are also useful instruments if you need to pay for a surprise expense and choose to finance it over dropping the cash which you may or may not have.
In this article, we’ll discuss loans, the different types and how they work.
What Is a Loan?
A loan is an amount of money a person borrows from a person or company. The entity lending the money — the lender — disperses the loan amount to the borrower or payee. Loans come with interest rates and a set number of years the borrower has to pay it back. It’s the role of the borrower to steer clear of financial trouble and make regular monthly payments to keep the loan in good standing.
To get a loan — and a favorable interest rate — lenders usually require that a borrower has a good credit score and other creditworthiness factors. (Although you can shop multiple lenders and find one to work with you and your situation.)
There are secured loans and unsecured loans:
- A secured loan is backed by collateral, like your house with a home equity loan.
- Alternatively, an unsecured loan doesn’t require any collateral, like a student loan.
For the latter, a lender might review your credit score and credit history to determine whether or not to approve your loan application.
What’s a Loan Interest Rate?
Interest rates refer to the amount of money you pay on top of the loan amount you borrowed. For example, if you finance a used car through an auto dealership, the dealer might add a 5% interest rate (which gets worked into the amount you pay for your monthly car payment). This fee is imposed by the lender; it’s how they make money off the loan.
There are two types of rates:
- Fixed interest rate: This is a set rate for the entirety of your loan.
- Variable interest rate: This is a fluctuating rate throughout the life of your loan.
Loans can have either fixed rates or variable rates. For example, you could get a fixed-rate student loan from the federal government (better yet, a subsidized loan where interest accrues starting at six months post-graduation) and a loan with a variable rate to pay for school expenses from a bank.
What’s a Loan Term?
Loan terms refer to the length of time a borrower has to pay back a loan. For example, a 30-year mortgage would require the borrower to pay off the loan within 30 years (unless it is refinances). There are short- and long-term options — you could get a loan that spans one year to a couple of decades. Your loan’s terms and conditions will vary depending on a number of factors, such as the lender and type of loan.
It’s important to stop here and state that borrowing money comes with risks. It’s essential to keep your loan payments regular and on schedule or you risk forfeiting your collateral (such as your car if you neglect to pay your auto loan) and hurting your credit score and credit history.
6 Types of Loans
There are many types of loans available to people who wish to borrow money. For this article, we’re going to concentrate on six major types of loans. (Unless otherwise specified, variable and fixed rates apply for each type.)
1. Personal Loan
A personal loan is a borrowed amount of money that can be used to fund a wide range of expenses. Personal loans work for a variety of uses since they’re versatile — the money can be used to pay for anything from home improvements to medical bills to debt consolidation.
There are unsecured personal loans and secured personal loans, and the money is typically paid out relatively quickly once you’ve been approved for the loan (within one to five business days). You can get a personal loan at banks, credit unions and other financial institutions, and personal loans are typically easier to qualify for compared to other ones. However, rates can also vary a lot for these loans and creep into the double digits.
2. Student Loan
Student loans are used to pay for education expenses. You can apply for either a private or federal student loan (or, in some cases, both). Depending on the type of student loan and its conditions, you might or might not qualify. For instance, a student loan specifically for people with bad or no credit might not allow loan money to be used for a for-profit college.
The U.S student loan debt total has reached a mind-blowing $1.7 trillion — so carefully weigh and understand your options before committing to a loan agreement. Federal student loans are both subsidized and unsubsidized, and these loans typically offer a six-month grace period after graduation before you’re required to pay the money back. Private student loans, which are offered through banks and online lenders, typically have higher interest rates.
3. Mortgage Loan
A mortgage loan is the money a lender gives a borrower (or, more specifically, a title company) for a home purchase. Buying a home can be an intense process, and there are many available mortgage options (conventional, VA, FHA loans, etc.). Depending on the type of loan you get, interest rates will vary. The current rate for a 30-year, fixed-rate conventional loan is hovering around 5%.
4. Auto Loan
Auto loans go toward the purchase of a car or other automobile. If you finance via a dealership, you might encounter an auto loan with a higher interest rate; however, a dealer might match a comparable rate at a bank or credit union, especially if you have a good credit score. To jump off that point, many online lenders, brick-and-mortar banks and credit unions offer car loans.
5. Payday Loan
A payday loan is a short-term, high-cost loan that’s usually for $500 or less, according to the Consumer Financial Protection Bureau. These loans are repaid via a borrower’s next payday, hence the name. Payday loans often have a reputation for being predatory — rates have been known to fall in the three-digit range — and many state laws regulate or even prohibit these types of loans.
6. Business Loan
A business loan is pretty self-explanatory: It’s a loan that’s borrowed to help fund a business. This money can be used to pay for business needs, such as office renovations or new technology for your staff. You can get business loans through the usual outlets and typically secure rates under 10%.
How to Apply for a Loan
First, you want to make sure your credit and financials are in good standing order. Then, get clear on the amount of money you *need* (emphasis on need, not want) to borrow.
- Shop around for lenders (consider rates, the amount you can borrow, fees and terms)
- Then, fill out an application and provide required documentation (likely a mailing address, government ID and your social security number, to name a few)
- Provide details about your employment and income
- For some loans, you’ll need to provide information on your assets and other financial documentation
Depending on the type of loan and how you apply — in person, online or by phone — you might get approved in a matter of days. For instance, you can usually get approved for a personal loan within a week.
How to Qualify for a Loan
Again, certain loans have more strict requirements to get lending. But, for the most part, you’ll want to have the following in order:
- A credit score that’s good or excellent (you can secure loans with scores that are lower, but you may have a higher interest rate and face other less favorable terms)
- A steady work history (mortgage lenders usually like to see a two-year job history)
- If you have a poor or no credit history, consider seeking out a reliable cosigner
These items can help increase your chances of getting approved for a loan. Your approval typically hinges on several factors, such as your credit score, the results of your credit report and your overall creditworthiness.
What to Look at When Applying for Loans
When looking for loans, consider the following before you apply:
- Check out alternatives to traditional banks and credit unions (an online-only lender or financial institution may provide more favorable rates and loan terms)
- Calculate the approximate monthly payment
- See if there are any origination fees or prepayment fees
- Look at interest fees, and review fixed interest rates versus variable interest rates
Although this might seem obvious, before you borrow money, make sure it’s absolutely necessary — you don’t want to compromise your financial situation by taking on debt you don’t need.
Frequently Asked Questions (FAQs) About How Loans Work
There are a lot of questions about how loans work and we’ve rounded up the answers to those mostly commonly asked.
Loans are paid back monthly from the borrower to the lender. The borrower pays back the monthly payment, plus the interest rate or annual percentage rate (APR), which includes other fees. Some loan payments can be debited from your checking or savings account, and certain lenders will give you a break on the interest if you do so.
When you start paying a loan back depends on the loan type and terms. For instance, federal student loans usually offer undergraduates a six-month grace period where they don’t need to make a single payment. On the contrary, you’ll start paying an auto or house loan in monthly installments right away.
Check your loan terms for information on your particular agreement. Also, take note that some lenders charge a prepayment penalty — so be mindful of how much funding you take on and the payback period to avoid this fee. For reference, there are no prepayment penalties when paying off education loans early, according to FinAid.org.
Once you figure out the amount you need to borrow, the loan process generally follows this format:
- Shop around (online or in-person) for the best rates and terms
- Prepare any required documents and apply for the loan (depending on the loan type, it might take a day or two or more than a month to be approved or receive your funds)
- Once you’ve been approved, you or the payee will receive the funds
- From there, follow the loan terms and conditions, and adhere to your monthly payments
For example, say you get a personal loan for $10K to replace the refrigerator and oven in your kitchen that both decided to stop working within a week of each other. You have good credit and decide to go with your current bank to secure the funds quickly. If you get an unsecured personal loan for $10K with an APR between 6% and 9% and a 36-month term, you’ll pay between $383.36 and $446.79 per month until it’s repaid.
Loans can hurt your credit score if you have a high debt-to-income ratio or pay your loans back late (or not at all). As you pay your loan back regularly and on time, your score shouldn’t suffer too much (and it should go up as your debt diminishes).
The timeframe when you start paying back a personal loan depends on the loan’s terms and conditions. But, you’ll likely start paying back a personal loan within 30 days after you receive your money.
Contributor Kathleen Garvin (@itskgarvin) is a personal finance writer based in St. Petersburg, Florida, and former editor and marketer at The Penny Hoarder. She owns a content-writing business and her work has appeared in U.S. News, Clark.com and Well Kept Wallet.