In the financial industry, a loan is a sum of money lent to a borrower for a specific amount of time. After receiving their approved loan, the borrower will repay the funds in either a lump payment or monthly installments.
How Do Loans Work?
- Step One: Apply – Start the loan process by submitting an application. Depending on the lender, you may be able to submit an application online, in person, or over the phone.
- Step Two: Work With Your Lender – Next, your lender will give you an approval decision based on the information provided in your application.
- Step Three: Get Your Money – Lastly, your lender will give you a loan contract to sign. Your contract is a loan document containing all the important information about your loan, including:
- Loan amount.
- Terms
- Rates.
- Any applicable fees.
Read over your contract to ensure you understand everything. Ask your lender if you have any questions. Once you feel comfortable with your loan deal, sign your contract. After that, you will receive your approved loan funds!
Why Do People Get Loans?
People can take out loans for just about any reason, but some of the most common are:
- Debt consolidation.
- Home purchase.
- Vehicle purchase.
- Education expenses.
- Business ventures (opening new businesses or expanding an existing business).
- Home improvements.
- Medical expenses.
- Emergency situations (natural disasters, major accidents, etc.).
- Personal situations (funerals, necessary traveling, weddings, etc.).
How To Find the Right Loan for You
Getting a loan is an important decision. That’s why you should take all the necessary steps to make sure you find the very best deal for you!
- Consider Alternatives – Can you borrow money from a close friend or family member? Do you qualify for assistance through programs offered by government agencies? Is there enough in your savings to cover your expenses? Considering your alternative options could help you avoid interest rates, finance charges, and other costs that come with most loans.
- Check Your Credit Score – Get as much information as you can about your current financial history. The best place to find this info will be on your credit report. You can request a free copy of your credit report from one of the major credit bureaus or check your unofficial report online.
Your most recent credit report and credit score will help guide you toward suitable lenders and weed out ones that wouldn’t be a good fit. For example, financial institutions like a bank may only accept borrowers who have excellent credit. Other types of lenders, like bad credit lenders, may be willing to work with a wider variety of borrowers. - Research Your Options and Compare Offers – If you decide that getting a loan is the best decision for you, do some research on the lenders and products available. Check out online reviews to see what other people think of a lender, call around to speak with various loan agents, and compare offers from multiple lenders. You may even be able to negotiate a better deal with one lender by using an offer from another lender as leverage.
- Apply and Get Paid – Once you decide on the right lender for you, submit an application. To avoid excessive damage to your credit score, try not to apply to multiple lenders within a short period of time. The best practice would be to submit just one loan application. From there, you can work with your lender and get your cash once approved!
Types of Loans
Loans can come in many different forms. Specific details like funding amounts, interest rates, terms, and more can vary depending on the type of financial institution you go with and the funding product you choose.
Secured Loans
A secured loan is a type of funding where the lender requires collateral. Collateral is a piece of personal property with value that the owner is willing to use as security for a loan. Common forms of collateral include homes, real estate, cars, and sometimes even jewelry.
Secured loans can be convenient for some borrowers because lenders typically base approval on the equity in the collateral instead of on the financial history of the applicant. And so, secured loans can make it easier for borrowers with a less-than-perfect credit history to receive approval for funding.
However, secured loans come with their own set of risks all consumers need to be aware of. Should the borrower fail to keep up with their loan payments or default on their loan, they risk losing whatever property they used as collateral.
Home Equity Loans
A home equity loan is a type of funding that uses the borrower’s real estate as collateral. Home equity loans can be used to refinance an existing mortgage loan or for other purposes. Similar to a home equity loan, borrowers may also access a home equity line of credit by using their property as collateral. Home equity lines of credit work more like a credit card but still use the borrower’s property as collateral.
Auto Loans
An auto loan, also called a car loan, is funding used for the specific purpose of purchasing a vehicle. After you pay off your auto loan, you will be the sole owner of your vehicle, allowing you to use its equity for other purposes if you want.
Car Title Loans
Similar to auto loans, a car title loan is a type of funding that uses the borrower’s vehicle as collateral. However, with title loans, the borrower must own their vehicle outright and have a free-and-clear car title. This is because the lender needs to sign onto the vehicle title as a lienholder when the borrower gets a title loan.
Unsecured Loans
An unsecured loan is a kind of funding that does not require collateral. Instead of basing approval on how much equity is in a borrower’s collateral, lenders look at other aspects of their financial history. This can include:
- Credit score.
- Income.
- Debt-to-income ratio.
Standard Personal Loans
A personal loan is a versatile form of credit borrowers can use for a variety of expenses and financial emergencies. While a personal loan may come with either fixed or variable rates, it’s more common for personal loans to have fixed interest rates. These fixed rates can make paying back personal loans much easier and more manageable for borrowers looking to get their finances organized or who are new to financing.
Cash Advances
A cash advance loan is funding meant to help borrowers who are waiting for their next paycheck. Payday loans are one of the most common examples of a cash advance loan.
Unlike standard personal loans, cash advance loans are typically paid back in one lump sum payment or over the course of about two weeks or less. These loans almost always come with extremely high-interest rates, making this type of funding predatory in the eyes of many consumers.
Demand Loans
Demand loans are a type of extreme emergency loan where borrowers can receive immediate funding. This type of loan is usually paid back in one lump sum payment and can come with serious consequences if borrowers fail to repay.
When To Get a Secured Loan vs. Unsecured Loan
If you have collateral you are willing to use and understand the risks, secured loans may work fine for you. To avoid falling into a debt trap, you may only want to consider secured loans for financial expenses you can pay off within a short period of time (usually a few months or less).
Unsecured loans may work better for consumers with a more stable credit history or who need a long-term funding solution.
Revolving Credit
Revolving credit is funding borrowers have renewed access to on a regular basis (usually monthly).
Credit Cards
Credit cards are amongst the most common types of revolving credit. Based on information from the U.S. Chamber of Commerce, approximately 175 million people have credit cards. Consumers may access standard credit cards, which allows them to make purchases on credit and pay them back later. There are also reward credit cards that offer borrowers perks the more they spend against their credit limit.
Credit cards work best for borrowers who are able to regularly pay off their balance. Neglecting to pay off a balance while continuing to make purchases on credit puts borrowers at risk of accumulating overwhelming credit card debt.
Components of a Loan
Let’s take a look at a breakdown of the average loan. The general components that make up a loan are:
- Qualification: Some lenders have strict qualification requirements for borrowers, while others are more lax. This is why you want to be familiar with your credit score, income, debt, etc., before submitting a loan application.
- Loan Amount: Your loan amount is the total amount of money lent to you by the lender. Note: You never have to borrow more money than you need!
- Interest Rates: Your interest rate plays a major role in determining the total cost of the loan. Fixed rates typically come with a correspondingly fixed monthly payment, while variable-rate loans have fluctuating rates and monthly payments. According to the Chamber of Commerce, the average interest rate for personal loans can vary between 10% and 28%.
Other factors that will help determine your interest rate are your credit history, loan amount, and terms. Borrowers who have a lower credit score may have to deal with a higher interest rate, while borrowers with excellent credit may qualify for lower rates. - Loan Terms: Your loan terms indicate how long it will take to pay off your loan. Your loan amount and monthly payments will play the most important roles in determining how long your loan terms are.
- Monthly Payments: Most loans are paid back in installments, contributed by borrowers on a monthly basis. It’s important to stay consistent with your monthly payments, so make sure they are for an amount you can easily afford.
- Fees or Penalties: Just about every loan comes with additional fees. Common fees you may encounter with a loan are origination fees or late payment fees. Other less common fees include prepayment penalties or hidden charges.
All fees and potential penalties should be clearly laid out in your loan contract, which is why it is so important to read it over and understand everything before signing!
How To Reduce the Cost of a Loan
Below are a few tips that may help you pay off loans faster and potentially save some money along the way!
- Make all your payments on time.
- Pay more than your minimum monthly payment.
- Refinance for a better deal if necessary.
How Do Loans Affect My Credit?
Depending on how you handle them, loans can have a significant positive or negative impact on your credit score and credit report. Borrowers who successfully pay off their loans with consistent monthly payments may see an improvement in their credit over time. On the other hand, irresponsible borrowers who make late payments or default on their loans may suffer from a lowered credit score for up to seven years.
References:
Personal Loan Statistics | Chamber of Commerce