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Basics of Loans
There are as many types of loans out there as there are reasons you might need to borrow money. While there are some loans that are very specific as to what they’re provided for, such as student loans, there are others that can be used for a wide variety of purposes, such as a personal loan. And like anything else provided by a private company, you can shop around to find the best possible terms on your loan.
Loans work in the same general way regardless of the type or purpose. You sign a contract agreeing to the terms of repayment, and the money is provided to you. You then make payments in accordance with that contract, and if you fail to do so, there are consequences. Before you sign any loan agreement, it’s important to understand the loan you’re taking out and make sure it’s the right choice for you.
Types of Loans and Their Purpose
The purpose of any loan is much the same: to allow someone to access a large amount of money up front and pay it back over time with interest as a benefit to the lender. Humans have had some system of lending for thousands of years. One of the first recorded lending systems was found in Mesopotamia, where farmers would borrow seeds on promise of a future harvest.
Lending has become far more complex since then, and today there is a type of loan for just about every need. Modern financial institutions follow strict practices that are regulated by law. There are two main types of loans: secured and unsecured, and within those categories an array of different types of loans.
Secured Vs. Unsecured Loans
An unsecured loan is one given without collateral, and tends to have much higher interest rates because there’s nothing that can be repossessed if there’s a default on the loan.
There are a few common types of unsecured loans:
- Student loans
- Personal loans
- Credit cards
Because these types of loans represent a higher risk to the lender, they tend to require a higher credit score and also have a higher interest rate.
Secured loans, on the other hand, involve some sort of collateral. A pawn shop is a common, easily accessible method of getting a secured loan. You bring in something valuable that you own, like a diamond ring, and the shop owners give you cash in return, then hold onto the ring for a specified period of time to allow you to pay the loan back. If you pay the pawn shop back, you get your item back. If you fail to pay it back, they can then sell the item to get their money back. Your diamond ring is collateral.
Other secured loans include:
- Home loans
- Car loans
- Financing expensive items like furniture or a television
If you default on this type of loan, the lender can simply take back the item for which the loan was provided. In home loans, that’s known as foreclosure. Because the lender has some way to recoup their money, secured loans tend to be easier to get and have lower interest rates.
Credit Cards and Personal Loans
The credit card is probably the most common type of loan out there, and the average U.S. family carries just over $6,000 in credit card debt according to the Federal Reserve. Credit cards are known as revolving debt because unlike a standard loan you can continually borrow and pay back up to the credit limit.
Credit card interest rates and limits vary widely based on the creditworthiness of the applicant. Credit cards are competitive and there are many of them out there. In fact, credit card companies often offer perks to draw in those with the best credit, such as cash back, airline miles, and other benefits.
There are cards designed for various needs as well, such as cards with low balance transfer rates for consolidating debt, and cards designed for students who have not yet established much of a credit history.
Personal loans are a similar type of loan to a credit card in the sense that they are offered based on creditworthiness and are unsecured. Unlike a credit card, a personal loan has set terms (interest rate, length of the loan, payment amount, etc.), and when it’s paid, off the agreement ends.
The most common secured loans are home and car loans. These two major purchases require borrowing for most people, as few have enough cash on hand to buy a new (or even a used) car outright (much less a house).
A home loan, better known as a mortgage, is the largest amount of debt most people will take on in a lifetime. Mortgages are available from most major financial institutions, and are paid back over a long period of time, usually 30 years. In most cases, the borrower is required to make a down payment, which serves several purposes. First, it lowers the amount being borrowed, and second, it creates some equity.
Equity simply refers to the amount of the value of the home that is above the amount owed. For example, if you owe $150,000 on your home and it’s worth $200,000, you have $50,000 in equity. This is good for both you and the lender; even if the market changes and the value of your home goes down, you have some wiggle room before you’re “upside down” or “underwater” (owing more on something than it’s worth).
Home equity loans are a form of home loan that you can borrow against the equity in your home. In the example above, you can borrow up to $50,000. Homeowners often use these loans for renovations that will increase the value of the home, creating more equity.
Car loans are very similar in function to a home loan. The term length of your car loan will vary, and most places will allow you to choose how long you’d like to take to repay with the max being around five-to-seven years, depending on the lender. A shorter loan means higher monthly payments but also less interest paid in the end. A longer term will mean you make lower monthly payments, but pay for a longer time period and thus pay more interest.
You can also find yourself upside-down on a car, and unlike a home where the value of your home is likely to increase over time, most cars will continue to depreciate, or lose value, over time. That makes them somewhat riskier for lenders.
Student debt gets a lot of attention in the media, with many pushing to find ways to reduce it. With post-secondary education costing more than ever, few students get through even an undergraduate degree without needing to borrow money.
Student loans are technically unsecured, but are given based on the belief that the education for which they are paying will increase the earning potential of the borrower. Thus, the loan should be easier to pay off when the education is complete. The longer you go to school, the more money you can expect to make when you graduate. At the same time, you’ll need more money to pay for that schooling.
Not surprisingly, doctors, dentists, and other medical professionals are among those with the highest amount of student loan debt. Thankfully, programs exist to help with paying off student loans.
Small Business Loans
Like a student loan, a small business loan is given on the expectation that it will result in the borrower making money in the future. Financial institutions will expect to see a business plan that outlines how the loan will be used and how it will result in the creation of a profitable business.
While creditworthiness is a big part of getting a small business loan, so is the business plan for which you’re requesting the money. Because these loans are often large, lenders can require collateral in the form of personal assets — like you house. Defaulting on a business loan can therefore be disastrous for the borrower on many levels.
Cash Advance and Payday Loans
You’ve probably seen ads for this type of loan on television, or seen a storefront offering them. Cash advance and payday loans operate by providing cash right away based on the borrower’s ability to pay the money back in a short period of time — by payday.
These loans have come under a lot of scrutiny for predatory practices. They tend to appeal to people in dire straits — the rent is due but payday is next week, so you borrow it now and then wind up paying back extra in interest. That tends to result in being short on that cash for the next pay period, which can create a cycle. These loans should be approached with a great deal of caution.
Loans and Credit
Credit is a concept that has been around for a long time. Thousands of years ago it was simply a matter of reputation, but today credit is a complex system of reporting most of your financial moves.
There are three main credit reporting agencies in the U.S. today. These are Experian, TransUnion, and Equifax. These companies record every time a person uses or applies for credit, along with some other financial information. These records are reported by your bank, credit card issuer, or lender every month or as they occur (in the case of a credit application).
Your credit score as you know it is something that was created by the Fair Isaac Corporation (FICO) and calculates the level of risk you represent to lenders based on your credit report data. Scores range from 300 to 850. These scores are used in the vast majority of lending decisions.
A FICO score is based on several factors:
Payment history (whether you have made payments on time)
Amount owed (how much money you owe, which is expressed as a ratio of how much you owe to how much credit you have available)
Length of credit history (how long you have been building credit)
Credit mix (the types of loans you have taken out)
New credit (recently opened lines of credit)
The first two factors on this list make up 65% of the FICO score, so they’re the best ways to improve it.
A good FICO score is generally viewed as between 670 to 739. Above that, you move into very good and excellent credit. Below that, you land in the fair and eventually poor credit categories. This will directly affect your ability to get a loan as well as the interest rates you will be offered on that loan.
Your credit score is constantly changing, and you do have some control over whether it improves or declines. First of all, it’s important to keep an eye on your credit. Errors do occur, and if you spot a mistake, you can request that it be corrected. The sooner that happens, the sooner your score will go up. And, of course, using credit wisely, making payments on time, and avoiding repeated requests for new credit will also help.
Defaulting on a Loan
The term “defaulting” is used to describe someone who has failed to make payments in accordance with the terms of the loan. Financial institutions have any number of responses to a default.
First, they will make an effort to get you back on track. Most companies will reach out to the borrower, remind them that a payment is due, and encourage them to pay as soon as possible. Some may even provide a grace period in which the borrow has time to make the late payment without consequences, but others will immediately penalize the failure to pay.
For example, if you miss a monthly payment on a credit card, you may be charged a late fee. If you had a special introductory rate on that card, you may find your rate goes up as a result of missing even one payment.
The longer you go without paying, the heavier the penalties will become. Credit card companies will turn off your ability to use the card or forfeit earned rewards with the card. You’ll get phone calls and letters. Eventually, a collection agency will be brought in to attempt to collect on the debt.
With a secured loan, the lender will eventually repossess the item you purchased on credit. Defaulting on a home loan will result in foreclosure proceedings, which will eventually mean you have to move out of the house and the bank will take ownership.
Every time you default on a loan, it hurts your credit score. That makes it harder to get more credit in the future.
Interest and How it’s Calculated
Interest is the amount of money you pay to the lender on top of the amount owed in return for the loan. Interest rates can vary widely, and as noted above depends on whether or not the loan is secured and your creditworthiness. Interest is calculated in a variety of ways.
Simple interest is the most basic type of calculation and the easiest to understand. If your interest rate on a $10,000 loan is 5%, and you are paying it back over five years, then the total amount of interest you will pay is $2,500.
The calculation is simple: The amount of the loan ($10,000) multiplied by the interest rate (.05), multiplied by the number of years (5).
The approach used in most home, car, and even student loans is an amortizing approach. It’s more complex, and the amount of interest versus the amount of principal (the amount owed) changes over time. It’s constantly being recalculated based on how much you’ve paid off.
As the amount of the loan balance goes down, you pay less in interest and the more you pay to the principal, although the amount you pay each month remains the same. That means that as you reach the end of the loan, you’re paying more on the principal and less on the interest.
So, for example, in the first year of a 30-year loan, 90% of your payment may be going to interest and only 10% to the principal, while in the final year of the loan, those numbers are reversed.
Interest and Credit
Your credit directly affects the interest rate you will be offered. Those with the best credit will qualify for the lowest interest rates (sometimes even no-interest loans and special offers). The better your credit, the lower the interest rates you will earn.
As your credit improves, the opportunity to refinance to a lower interest rate will likely represent itself. Most loans can be refinanced, from home loans to even credit cards (a process that is usually done through a balance transfer to a new card).
Taking out loans and repaying them is part of building credit and creating a good reputation for yourself so that lenders will see you as a safe bet. That’s why starting young with small loans, such as a low-limit credit card, can be a good first step towards getting that low mortgage rate in the future.