Loan Concepts and Key Definitions
Loans are an agreement where you receive money now and pay it back later, either over a specified period or as a lump sum. To compensate the lender who provides the money, you typically pay back a larger amount than you received. These repayments may include financing charges upfront at the time of borrowing or interest and other fees over time.
Note: Loans allow you to spend the money you need now and repay it in the future.
How Loans Work
When you need money, you ask a lender to provide the funds. To do this, you typically submit an application or “apply” for a loan, and the lender decides whether to approve your request. The lender makes their decision based on your ability to repay – their assessment of whether you will repay the loan.
Note: Your ability to repay is based on several factors, but among the important factors are your credit history and your available income to repay the loan.
The Cost of Money
In exchange for receiving money from someone else, you usually pay back a larger amount than you borrowed. With most loans, you pay a percentage of the borrowed amount as interest. You may also have to pay other fees such as loan origination fees, finance charges, or other costs.
Types of Loans
Loans come in a variety of forms, but most loans fall into two main categories: installment loans and revolving loans.
Installment loans are one-time loans that provide borrowers with funds upfront. You repay the installment loan over time, often with fixed monthly payments. A portion of each payment goes toward interest costs, and the remaining amount reduces the outstanding loan balance. These loans can also be known as amortizing loans. Common examples of installment loans include mortgage loans, auto loans, personal loans, and many student loans.
Revolving loans allow you to borrow and repay repeatedly. Instead of receiving funds upfront, you have the ability to draw from a credit line up to a maximum limit. Repayment requirements depend on the specific loan details. Examples of revolving debt include credit cards and home equity lines of credit (HELOCs).
Loans can be classified as either secured or unsecured. Secured loans require collateral to “secure” your debt. If you fail to repay the loan, lenders can take the collateral and sell it in hopes of recouping your remaining loan balance. For example, if you fail to repay a mortgage loan, lenders may foreclose on your home, forcing you to find new housing and damaging your credit. Unsecured loans do not require collateral. Lenders approve these loans based on your ability to repay, and there are no specific assets for them to seize. However, if you fail to repay, lenders can report missed payments to credit bureaus, making it harder for you to borrow in the future and taking further actions to collect what you owe.
Interest Costs
When borrowing money, it is important to understand how interest is charged so you can minimize costs and prevent debt from spiraling out of control.
Simple Interest: Installment loans like fixed-rate mortgages charge simple interest on your loan balance. As a result, interest costs decrease over time as you pay down your loan balance.
Compound Interest: With other loans, including credit cards, lenders may add interest to your loan balance. If you do not pay enough to cover the interest costs, your loan balance can increase over time, and you pay interest on that new interest each month. In other words, you pay interest on money you never even spent.
Important
Prices: Interest rates are an important factor when borrowing, and lower rates make borrowing more accessible. With installment loans, the interest rate affects the monthly payment (which impacts your cash flow each month until the debt is paid off). Therefore, it makes sense to improve your repayment capacity to qualify for the lowest possible rates.
How can different interest rates affect your payment? Use our personal loan rates to find out.
What to Be Cautious About
A loan is a powerful financial tool, but you should be aware of a few things.
Rate Changes: With some loans, interest rates can change over time. For example, adjustable-rate mortgages can periodically rise. If rates go up, the required monthly payment also increases, which can be an unwanted surprise. Fixed-rate loans do not have adjustment features, making them more predictable.
Focusing on the Payment: The monthly payment affects your cash flow, but it should not be the primary factor behind your decisions. You can achieve a low monthly payment in several ways. For instance, you can extend the repayment period, choosing a 30-year mortgage instead of a 15-year loan. However, the longer you borrow, the more interest costs you will incur, so it may be better to choose a higher payment.
Restrictions: Access to cash is great, but loans can severely limit your freedom and lead to problems. With heavy loan payments, it becomes difficult to move or change jobs, and you have less disposable income if you need to apply for a new loan.
Note: Try to minimize borrowing as much as possible with a large down payment and only spend what you need.
Conclusion
Loans are a powerful financial tool that can open doors for you and cause problems. Therefore, it is essential to understand how loans work from the ground up. Learn about the different types of loans and how to pay for interest costs. Be cautious of rate changes and do not focus solely on the monthly payment. Avoid borrowing as much as possible by making a large down payment and using money wisely.
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Source: https://www.thebalancemoney.com/what-loans-are-and-how-they-work-4767429
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