Loans: How Loans Work

Key Takeaways:
  • Loans involve borrowing money that you need today and promising to pay it back in the future.
  • You have to apply and qualify to borrow with a loan.
  • There are many types of loans including mortgages, personal loans, auto loans, student loans and business loans.

Borrowing money can help you achieve the lifestyle you want. However, borrowing mistakes can make your life miserable for years to come. 

In order to borrow successfully, it’s important to understand how loans work. This guide covers the essentials, including

  • Basic loan language explained

  • How a loan works

  • Types of loans

  • How to get a loan

  • How do loans work: FAQs

This guide can help prepare you to borrow money successfully, and act as a reference any time you have questions about loans. 

Basic Loan Language Explained

There’s a lot of jargon associated with loans. Don’t be intimidated -- it’s not as complicated as it seems. Most of the concepts are actually pretty simple if you look at them one by one. 

Principal. This is the amount you owe. It starts out as the amount you borrow and falls as you pay the low down. When your principal balance hits zero, you’ve paid off your loan.

Interest. This is what you pay lenders for tying up their money. Interest is usually computed as a percentage of the amount you owe.

Fixed interest rate. In this context “fixed” means that the interest rate stays the same throughout the life of the loan.

Adjustable interest rate. In contrast to a fixed-rate loan, an adjustable-rate loan’s interest rate may change at specific times during the loan’s life according to formulas that are spelled out in loan documents. Typically, the interest rate is tied to a published financial index and moves up and down as the index changes.

Repayment term. This is the period over which you have to repay the loan. It’s simple – if your loan has a ten-year term, for instance, you repay it over ten years (120 months). 

Loan fees. In addition to interest, some lenders charge fees. There can be many types including application and processing fees, origination fees, late charges, and prepayment penalties. Check your loan agreement for fees before you sign it because they can significantly increase the cost of a loan.

Amortization schedule. This is a table that shows how repayment will progress month by month over the life of the loan. It shows each month’s payment, how that payment breaks down into principal and interest, and how the amount you owe declines with each payment. This is an important tool for understanding how quickly you’ll pay your principal will be paid down and how much interest you’ll pay. 

Payment schedule. This is the schedule of how much you’ll owe every month and when each payment is due. It sometimes comes with coupons that you can attach you your checks, and then it’s called a “payment book.”

Lender. This is the individual or organization making the loan. Lenders can be banks, credit unions, specialty lending companies, credit card companies, and peer-to-peer intermediaries.

Loan servicer. This is the organization that processes your loan payments and handles any issues with your payments. Note that the servicer may be different from the lender, so it’s important to know where to direct payments and inquiries.

Secured loan. This is a loan guaranteed by collateral. Collateral means an asset that you pledge to the lender; if you don’t repay your loan, the lender can take and sell your collateral. Mortgages and car loans are common examples of secured loans.

Unsecured loan. This is a loan made with no collateral. Because it lacks that security, unsecured loans have higher interest rates than unsecured loans. 

Credit report. This is a history of how you’ve used credit in the past, including any late payments and bad debts. Credit scores are compiled by three large credit reporting agencies (CRAs)” TransUnion, Experian, and Equifax. 

Credit score. This is a score that indicates your creditworthiness. Lenders pull your credit report and apply a formula to it – a FICO or VantageScore – to generate a credit score. The higher your credit score, the more likely you are to get a loan and the lower the interest rate is likely to be. 

How a Loan Works

With all that terminology out of the way, here are the step-by-step basics of how a loan works:

  1. You submit an application stating the amount you want to borrow and what you want it for. You’ll provide information about your income, debts, assets, addresses and employment. You’ll also submit proof of income and other documents.

  2. Based on the information in your application and a check of your credit report, the lender may approve your loan as requested, approve with different terms, deny your application, or request more information. 

  3. If the lender approves your application, you’ll receive written, formal loan approval. 

  4. The lender considers your risk as well as market conditions to decide what interest and fees to charge you for the loan. Your loan documents should spell out the terms of the loan: your interest rate, fees and conditions, and payment schedule. 

  5. Review the loan documents and decide if you agree to the terms.

  6. If you agree to the loan’s terms, you’ll sign a loan agreement. You’ll pay any down payment or fees due.

  7. After receiving and processing the final loan documents, the lender funds the loan. You might get a check or a transfer into your bank. If you’re using the money to buy a house or car, the lender pays the loan proceeds to the seller. If you get a debt consolidation loan, the funds might be sent directly to your creditors.

  8. You’ll begin making payments according to your payment schedule.

  9. When your balance reaches zero, your loan is paid off. The lender releases any claim on your collateral and you should receive a payoff letter. 

Types of Loans

Many loans are geared toward specific purposes. Here are some common types of loans:

Student loans

Student loans cover educational expenses like tuition, room and board, textbooks and computers. 

Most student loans in the United States are backed by the federal government. This helps make them available to people with little or no credit history, and keeps interest rates relatively low.

Federal student loans have other advantages over privately-issued loans. They may offer a variety of repayment options, and typically do not require repayment while you are still in school. 

To qualify for a federal student loan, you must enroll in an eligible program at an accredited institution. You can apply for a federal student loan, along with other federal student aid, using the Free Application for Federal Student Aid (FAFSA) online. 

Personal loans

You can use personal loans for almost any legal purpose, though you may have to specify the purpose when applying. However, many lenders do not approve personal loans for paying off student loans. 

Personal loans may be secured or unsecured. A secured personal loan requires collateral that you must surrender to the lender if you fail to repay what you owe.

Unsecured loans are riskier for lenders and typically have higher interest rates than secured loans. Getting an unsecured loan depends greatly on your personal creditworthiness.

Payday loans

Payday loans, also called cash advance or check advance loans, come in small amounts (often just a few hundred dollars), and their terms are very short – a few days to a month.

Because they are repaid all at once, payday lenders charge a flat fee rather than interest. This is usually a very expensive way to borrow. For example, the Consumer Financial Protection Bureau points out that a typical payday loan may charge a $15 fee on a $100 loan to be paid back in two weeks. That’s the equivalent of paying a 400% annual rate of interest. Worse, many borrowers can’t repay the loan and have to roll it over (often several times), increasing the balance and incurring a new set of fees with every rollover.

Mortgage loans

A mortgage is a loan with real estate as collateral. They usually require a down payment and have strict qualifying standards.

Most mortgage loans have terms of 15 or 30 years, with 30-year mortgages being most common. Longer loans have lower monthly payments than shorter-term loans. However, they tend to be more expensive because their interest rates are higher and because you borrow for a longer time. 

Banks, credit unions, mortgage companies, brokerages, insurance companies and other providers offer mortgages. Most government-backed loans are insured by the government but funded by private lenders.

Home equity loans

Home equity loans are also mortgages backed by real estate. The “home equity” that you borrow against is the difference between the current value of your home and your current mortgage balance.

You can borrow against this equity for a variety of purposes, including home improvement, debt consolidation, education or other purchases.

Auto loans

Auto loans are specialized financing for the purchase of new or used cars, Typical repayment terms range from three to ten years. Loans with longer terms have higher interest rates. Stretching out repayment lowers your monthly payment but increases the overall cost of the loan.

When you finance a car, especially a used car, choose a loan term that won’t exceed the useful life of the vehicle. Otherwise, you may still be paying for your old car when it’s time to buy the next one. 

Business loans

While loans you take out as an individual depend on your personal credit history and finances, business loan approvals depend on the characteristics of that business. The cash flow, assets, liabilities, business plan and past credit history of the company are all important factors. 

If you are trying to launch a brand-new company, you may have to personally guarantee your business loan to get an approval. 

The Small Business Administration guarantees business loans, which are funded through private lenders. This government backing helps make loans more available and affordable. 

How to Get a Loan

Once you decide to take out a loan, here are some ways you can increase your chances of getting and using a loan successfully:

  1. Check your credit. Before you apply, check your credit history to make sure there aren’t any mistakes that need to be corrected or problems you can clear up.

  2. Budget before you borrow. Plan how you’ll make the loan payments with your current expenses and income. 

  3. Shop for a loan. Even small differences in loan terms can add up to a lot over the life of a loan, so shop carefully.

  4. Apply thoughtfully. Talk to lenders when you’re shopping, so you can apply where you’re likely to get approved. Then handle the application with care and attention to detail, and provide whatever the lender requests as soon as possible.

  5. Set up your payment schedule. Once you get a loan, make sure you know when your payments are due and where to make them. Setting up automated payments can help, but make sure there’s enough money available in your account on the payment date.

As you prepare for any loan, remember that the more you understand about how loans work, the more you are likely to get out of your loan.  

Frequently Asked Questions

What happens if I can’t make a loan payment?

If you absolutely can’t come up with your payment, contact the loan servicer to work something out. Missed payments can be costly in several ways: late penalties, additional interest charges, harm to your credit score and intrusive collection activities. The longer you let payment problems go, the worse they are likely to get.

Should I compare the interest rate or the size of the monthly payments to see which loan option is cheaper?

The size of the monthly payment is important for budgeting, but it won’t tell you much about the total cost of the loan. That’s because repayment terms vary – longer loans have lower monthly payments but higher costs over their lives. It’s good to compare interest rates for loans with the same repayment terms, but different loan lengths change the picture. Overall, this is where an amortization schedule is important. It helps you see the total cost over the life of the loan – though you also have to add in fees.

Will I save money on interest if I repay my loan ahead of schedule?

Normally, yes. However, some loans have prepayment penalties. That means lenders charge extra for paying early to make up for the interest they won’t get over the loan’s term. So, before paying early, check to see if any prepayment penalty involved would exceed the amount of interest you’d be saving.