What is Loan?- Types and How does it Work?

What is Loan?

A loan is a form of debt incurred by an individual or other entity. The lender usually a corporation, financial institution, or government advances a sum of money to the borrower. In return, the borrower agrees to a certain set of terms including any finance charges, interest, repayment date, and other conditions.

In some cases, the lender may require collateral to secure the loan and ensure repayment. Loans may also take the form of bonds and certificates of deposit (CDs).

A loan is a form of debt incurred by an individual or other entity.

How Does a Loan Work?

A loan is a commitment that you (the borrower) will receive money from a lender, and you will pay back the total borrowed, with added interest, over a defined time period.

The terms of each loan are defined in a contract provided by the lender. Secured loans are loans where borrowers can put up an asset (like a house) as collateral.

This gives the lender more confidence in the loan. Unsecured loans are loans approved without collateral, so the lender takes on more risk.

How Does Your Credit History Impact Your Interest Rate?

Before you can take out a loan, secured on unsecured, you first have to apply. Financial institutions and lenders will do a soft credit pull first to confirm you meet the minimum requirements to apply. If you move forward with an application, the lender will do a hard credit check to review your credit history.

If you want to review your own credit history you can request a credit report from one of the major credit agencies; Experian, Transunion, and Equifax. You can request a free report each year from each lender, so you can see what a lender will be reviewing.

Your creditworthiness will play a role in the interest rate offered. If you have a good credit score, the lender will have more peace of mind that you will repay your loan, and offer you a lower interest rate or maybe a larger amount of money.

If you have a lower credit score you might want to build your score back up before submitting a loan application to see a better loan offer.

Attributes of a loan

Loans generally have four primary features: principal, interest, term, and payment amount. Understanding each of these will help you decide if a loan is suitable for your purpose and how affordable it is.

  • Principal: This is the amount of money you borrow from a lender. It may be $500,000 for a new house or $500 for a car repair.
  • Interest: The interest rate is the cost of a loan, how much you have to pay back in addition to the principal. Lenders determine your interest rate based on several factors, including your credit score, the type of loan and how much time you need to repay the loan. Interest is different from the annual percentage rate, or APR, which includes other costs like upfront fees.
  • Installment payments: Loans are usually repaid at a regular cadence, typically monthly, to the lender. Your monthly payment is commonly a fixed amount.
  • Term: The loan term is how much time you have to repay the loan in full. Depending on the type of loan, the term can range from a few months to several years.

How Does a Loan Payment Work?

Loans are paid in pre-defined increments over the term defined. Say you make monthly payments towards your car loan; each payment will cover the interest due and some amount of the principal.

The more money you can apply to payment means more principal you knock out in each payment. Paying down your principal and wrapping up a loan quickly means you can save money you would have spent on interest payments.

How Do Payments Change Over the Life of a Loan?

As the principal due on the loan gets smaller with each payment, less interest accrues. This means that over time you will see less and less of your monthly payment going to interest payments, and more to the principal still due.

This is easiest to see in 15 or 30-year loans that shift gradually over a longer time period.

Types of Loans

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

Secured vs. Unsecured Loan

Loans can be secured or unsecured. Mortgages and car loans are secured loans, as they are both backed or secured by collateral.

In these cases, the collateral is the asset for which the loan is taken out, so the collateral for a mortgage is the home, while 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 factors including the borrower’s credit history.

Revolving vs. Term Loan

Loans can also be described as revolving or term. A revolving loan can be spent, repaid, and spent again, while a term loan refers to a loan paid off in equal monthly installments over a set period.

A credit card is an unsecured, revolving loan, while a home equity line of credit (HELOC) is a secured, revolving loan. In contrast, a car loan is a secured, term loan, and a signature loan is an unsecured, term loan.