What Is a LoanHow Does It WorkTypesand Tips on Getting One

What Is a Loan?

A loan is a form of credit where a specific amount of money is given to someone with the agreement that it will be paid back later. In many casesthe lender also adds interest or finance charges to the principal valuewhich the borrower must repay in addition to the principal balance.

Loans may be for a specificone-time amountor they may be available as an open-ended line of credit up to a specified limit. Loans come in many different formsincluding securedunsecuredcommercialand personal loans.

Understanding Loans

A loan is a form of debt incurred by an individual or other entity. The lender—usually a corporationfinancial institutionor government—advances a sum of money to the borrower. In returnthe borrower agrees to a certain set of termsincluding any finance chargesinterestrepayment dateand other conditions.

In some casesthe lender may require collateral to secure the loan and ensure repayment. Loans may also take the form of bonds and certificates of deposit (CDs). It is also possible to take a loan from a 401(k) account.

The Loan Process

Here's how the loan process works: When someone needs moneythey apply for a loan from a bankcorporationgovernmentor other entity. The borrower may be required to provide specific details such as the reason for the loantheir financial historySocial Security number (SSN)and other information. The lender reviews this information as well as a person's debt-to-income (DTI) ratioto determine if the loan can be paid back.

Based on the applicant's creditworthinessthe lender either denies or approves the application. The lender must provide a reason should the loan application be denied. If the application is approvedboth parties sign a contract that outlines the details of the agreement. The lender advances the proceeds of the loanafter which the borrower must repay the amountincluding any additional chargessuch as interest.

The terms of a loan are agreed to by each party before any money or property changes hands or is disbursed. If the lender requires collateralthe lender outlines this in the loan documents. Most loans also have provisions regarding the maximum amount of interestin addition to other covenantssuch as the length of time before repayment is required.

Why Are Loans Used?

Loans are advanced for a number of reasonsincluding major purchasesinvestingrenovationsdebt consolidationand business ventures. Loans also help existing companies expand their operations. Loans allow for growth in the overall money supply in an economy and open up competition by lending to new businesses.

The interest and fees from loans are a primary source of revenue for many banksas well as some retailers through the use of credit facilities and credit cards.

Components of a Loan

There are several important terms that determine the size of a loan and how quickly the borrower can pay it back:

• Principal: This is the original amount of money that is being borrowed.
• Loan term: The amount of time that the borrower has to repay the loan.
• Interest rate: The rate at which the amount of money owed increasesusually expressed in terms of an annual percentage rate (APR).
• Loan payments: The amount of money that must be paid every month or week in order to satisfy the terms of the loan. Based on the principalloan termand interest ratethis can be determined from an amortization table.

In additionthe lender may also tack on additional feessuch as an origination feea servicing feeor late payment fees. For larger loansthey may also require collateralsuch as real estate or a vehicle. If the borrower defaults on the loanthese assets may be seized to pay off the remaining debt.

Tips on Getting a Loan

In order to qualify for a loanprospective borrowers need to show that they have the ability and financial discipline to repay the lender. There are several factors that lenders consider when deciding if a particular borrower is worth the risk:

• Income: For larger loanslenders may require a certain income thresholdthereby ensuring that the borrower will have no trouble making payments. They may also require several years of stable employmentespecially in the case of home mortgages.
• Credit score: A credit score is a numerical representation of a person's creditworthinessbased on their history of borrowing and repayment. Missed payments and bankruptcies can cause serious damage to a person's credit score.
• Debt-to-income ratio: In addition to one's incomelenders also check the borrower's credit history to determine how many active loans they have at the same time. A high level of debt indicates that the borrower may have difficulty repaying their debts.

In order to increase the chance of qualifying for a loanit is important to demonstrate that you can use debt responsibly. Pay off your loans and credit cards promptly and avoid taking on any unnecessary debt. This will also qualify you for lower interest rates.

It is still possible to qualify for loans if you have a lot of debt or a poor credit scorebut these will likely come with a higher interest rate. Since these loans are much more expensive in the long runyou are much better off trying to improve your credit scores and debt-to-income ratio.

Relationship Between Interest Rates and Loans

Interest rates have a significant effect on loans and the ultimate cost to the borrower. Loans with higher interest rates have higher monthly payments—or take longer to pay off—than loans with lower interest rates. For exampleif a person borrows $5,000 on a five-year installment or term loan with a 4.5% interest ratethey face a monthly payment of $93.22 for the following five years. In contrastif the interest rate is 9%the payments climb to $103.79.

Similarlyif a person owes $10,000 on a credit card with a 6% interest rate and they pay $200 each monthit will take them 58 monthsor nearly five yearsto pay off the balance. With a 20% interest ratethe same balanceand the same $200 monthly paymentsit will take 108 monthsor nine yearsto pay off the card.

Simple vs. Compound Interest

The interest rate on loans can be set at simple or compound interest. Simple interest is interest on the principal loan. Banks almost never charge borrowers simple interest. For examplelet's say an individual takes out a $300,000 mortgage from the bankand the loan agreement stipulates that the interest rate on the loan is 15% annually. As a resultthe borrower will have to pay the bank a total of $345,000 or $300,000 x 1.15.

Compound interest is interest on interestand that means more money in interest has to be paid by the borrower. The interest is not only applied to the principal but also to the accumulated interest of previous periods. The bank assumes that at the end of the first yearthe borrower owes it the principal plus interest for that year. At the end of the second yearthe borrower owes the bank the principal and the interest for the first yearplus the interest on interest for the first year.

With compoundingthe interest owed is higher than that of the simple interest method because interest is charged monthly on the principal loan amountincluding accrued interest from the previous months. For shorter time framesthe calculation of interest is similar for both methods. As the lending time increasesthe disparity between the two types of interest calculations grows.

If you're looking to take out a loan to pay for personal expensesthen a personal loan calculator can help you find the interest rate that best suits your needs.

Types of Loans

Loans come in many different forms. There are a number of factors that can differentiate the costs associated with themalong with their contractual terms.

Secured vs. Unsecured Loan

Loans can be secured or unsecured. Mortgages and car loans are secured loansas they are both backed or secured by collateral. In these casesthe collateral is the asset for which the loan is taken outso the collateral for a mortgage is the homewhile the vehicle secures a car loan. Borrowers may be required to put up other forms of collateral for other types of secured loans if required.

Credit cards and signature loans are unsecured loans. This means they are not backed by any collateral. Unsecured loans usually have higher interest rates than secured loans because the risk of default is higher than secured loans. That's because the lender of a secured loan can repossess the collateral if the borrower defaults. Rates tend to vary wildly on unsecured loans depending on multiple factorssuch as the borrower's credit history.

Revolving vs. Term Loan

Loans can also be described as revolving or term. A revolving loan can be spentrepaidand spent againwhile a term loan refers to a loan paid off in equal monthly installments over a set period. A credit card is an unsecuredrevolving loanwhile a home equity line of credit (HELOC) is a securedrevolving loan. In contrasta car loan is a securedterm loanand a signature loan is an unsecuredterm loan.

The Bottom Line

Loans are one of the basic building blocks of the financial economy. By loaning out money with interestlenders are able to provide funding for economic activity while being compensated for their risk. From small personal loans to billion-dollar corporate debtslending money is an essential function of the modern economy.