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Learn About Personal Loans

10 Loan and Borrowing Concepts You Need to Understand

man and woman reviewing options before borrowing money

As if borrowing money weren’t stressful enough, you have to master a whole new vocabulary as you research and compare your loan options. It’s really important to understand these phrases and concepts so you can make smart financial decisions. If you don’t, it could cost you money in fees or interest. We’ve simplified some of the key terminology to get you started.

1. Term

The term of a loan is its lifespan. If the term is 36 months, for example, that’s how long you have to pay back the loan amount. The loan term may affect your monthly repayment amount. A longer term could have a smaller monthly payment. A shorter term might require a larger monthly payment. But, a longer term could also result in paying more in interest over the life of the loan. For that reason, it’s critical to think about what’s manageable for you. Before agreeing to a term, make sure you can commit to making the monthly payment amount for the duration of the term.

2. Fixed Interest Rate

Interest rates on loans are either fixed or variable.

Fixed interest rate loans have an interest rate that will stay the same throughout the length of the loan. Payments are predictable with no surprises due to interest rate hikes. People often choose fixed-rate loans to have peace of mind that their monthly repayment amounts will not change during the life of the loan.

With variable interest rate loans, on the other hand, the interest rate changes based on the economy and market conditions. You’ve probably heard news stories talking about the Federal Reserve raising or lowering interest rates. Loans that are based on the prime rate can see an increase or decrease in interest rate whenever the Federal Reserve decides to change rates.

Variable interest rate loans may start out lower than fixed interest rate loans. Sometimes when people refinance their student loans, for example, they choose a variable rate when rates are low. If you can commit to pay the loan off within a couple of years, and hopefully not see interest rate hikes on a large scale, this could work in your favor. The lower interest rate allows more of the loan payment to go toward paying off the balance more quickly, rather than toward interest if the rate was higher.

3. APR (Annual Percentage Rate)

An annual percentage rate is a combination of a loan’s interest rate plus fees that are charged, expressed as a percentage. Interest is a portion of the total amount, calculated as a certain percentage. The APR allows consumers to compare loan options to find the lowest overall cost to them as they pay back the loan.

However, a personal loan with a low APR doesn’t necessarily cost you less than a personal loan with a higher APR. Some lenders may include additional fees, such as origination fees, that could be included in the APR for the loan, effectively making the loan more expensive.

Thanks to the Truth in Lending Act (TILA), lenders are required to disclose their APR and other important information to borrowers when offering credit. Knowing how much you’ll potentially pay depending on the lender helps inform your search for personal loans.

4. Prepayment Penalties

Some lenders charge a fee called a prepayment penalty if you want to pay off some or all of your loan early. Prepayment penalties exist to protect the lender against losing money. A lender must disclose any prepayment penalties when the borrower applies for the loan.

This penalty is just one type of fee you may encounter when you apply for a loan. In addition to prepayment penalties, be aware of application fees and origination fees, as well as any fees you may face if something goes wrong with a payment.

Not all lenders charge a prepayment fee, so it may make sense to look for a lender that doesn’t. Discover Personal Loans, for example, doesn’t charge prepayment or origination fees

5. Secured Versus Unsecured Loans

There are two types of loans: unsecured and secured. Unsecured loans do not require any collateral (e.g. your home) to be put up to secure the loan. Borrowers in good financial standing—generally defined by one’s credit score—and a verified way to repay the loan (income or assets) are more likely to be approved than folks who don’t meet those criteria.

Secured loans are backed by collateral, such as a home or car, with a lien against that property. Secured loans generally offer a lower interest rate because the bank has your asset as collateral should you be unable to pay back the loan, and therefore is taking on less risk. If you do not repay the loan, the bank repossesses the asset that is securing the loan.

A personal loan is one example of an unsecured loan. Personal loan amounts can range from $2,000 to $50,000 or more, have a fixed interest rate and require only one monthly payment. They can be used to consolidate and pay down higher-interest debt or cover unexpected, large expenses.

Personal loans and other unsecured loans can offer nice options for borrowing smaller amounts of money at a fixed rate.

6. Amortization

Amortization is the process of paying down your loan balance over time. In the beginning, a small portion of the monthly payment pays off principal, with the rest going to pay interest. As the payments continue to reduce the balance, less interest is charged, and the principal payoff accelerates. At the end of an amortized loan, the majority of the payment is principal while only a small amount of interest is charged.

7. Debt Consolidation

Simply put: With a debt consolidation loan, you can pay off higher-interest debt. You can even combine multiple bills into one payment at a lower interest rate. Then you are responsible for paying one loan with a simplified, fixed monthly payment. Some lenders, like Discover Personal Loans, can pay your creditors directly. Over time you could save a significant sum in interest if you are able to consolidate your debt at a lower interest rate.

8. Refinancing

Refinancing means you essentially apply for a new loan with better terms than the current one. If you’ve improved your financial standing and have a good history of repayment, you may have the opportunity to refinance with the same lender or a different bank. Refinancing replaces your current loan with another one. A new loan could result in lower payments, lower interest rates or a shorter term, depending on your situation and the interest rate for which you are approved.

9. What is a Credit Report?

A credit report is an in-depth history of your borrowing habits and actions. The data reported includes detailed information, such as your account number, balance, payment history and minimum payment due. Some banks report credit limits, while others do not.

If you file for bankruptcy, have a tax lien or have a court judgment rendered against you, this negative information may also appear on your credit report. Additionally, the actions you take when you have secured a loan, such as paying on time, are reported back to credit bureaus.

It’s important to know what’s on your credit report before you apply for a loan so you can adjust any incorrect or outdated information. Some financial institutions may review your credit report and consider it when they approve your loan application.

10. What is a Credit Score?

Credit scores take into account your payment history, amounts owed, mix of credit types, length of credit history and new credit.

Many lenders consider credit scores in loan applications. It’s prudent to keep your credit score healthy and to regularly monitor your credit score. If your credit score changes dramatically, this could indicate an inaccuracy in your credit report that may be bringing your score down.

With Discover Personal Loans you can check your rate with no impact to your credit score.