Skip to content
Basics

10 Loan and Borrowing Concepts Everyone Should Understand

man and woman reviewing options before borrowing money

By Lee Huffman

 

If you’re thinking of borrowing money, it’s important to understand some key terms before choosing a loan or lender. Chances are you’ll see these terms when you research and review loan options, so avoid the temptation to gloss over them—they’re important to understand before finalizing any financial agreement. If you don’t, it could cost you money in fees or interest. So, we’ve broken down these key terms down so you can make more informed financial decisions.

1. Term

The term of a loan is its lifespan. If the term is 36 months, for example, that’s how long the borrower has to pay back the loan amount. The loan term may affect your monthly repayment amount, with a longer term sometimes having a smaller monthly payment and a shorter term sometimes having a larger monthly payment. The longer term may result in sometimes paying more in interest over the life of the loan, however, so 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. Think about what might work best for your financial situation.

Fixed interest rate loans have an interest rate that will stay the same throughout the length of the loan. People often choose fixed-rate loans to have peace of mind that their re-payments on these loans will not change. Therefore, payments are predictable with no surprise interest rate hikes.

Variable interest rate loans, on the other hand, have an interest rate that changes based on the economy and market conditions. You’ve probably heard news stories talking about the Federal Reserve changing interest rates. Loans that are based on the “prime rate” will have their interest rate go up or down 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, they choose a variable rate when rates are low. This can work in people’s favor when they can commit to pay the loan off within a couple of years, and therefore hopefully not see interest rate hikes on a large scale. The lower interest rate allows more of the loan payment to go toward paying off the balance quicker, rather than money going more toward interest if the rate was higher.

3. APR (Annual Percentage Rate)

The 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.

For example, say you’re shopping for a personal loan of $30,000. One bank is offering a rate of 7.99% with no fees or origination costs (APR of 7.99%). Another bank is also offering a 7.99% interest rate loan, but it has $1,236 in fees. This second loan would actually have an APR of 9.15% because of the fees. If you didn’t include the fees paid, you may think these loans have the same total cost.

4. Prepayment Penalties

“A prepayment penalty is nothing more than a fee that lenders charge if you want to pay off some or all of your loan early.” Prepayment penalties solely 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 pre-payment fee, so look for a lender that doesn’t. For example, Discover Personal Loans is one lender that 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. Those in good financial standing — usually based on your credit score — and a verified way to repay the loan income or assets are more likely to be approved than those that aren’t.

Secured loans are backed by collateral, such as a home, car, or boat, 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. In the case that you do not repay the loan, the bank repossesses the asset that is securing the loan.

One example of an unsecured loan is a personal loan. A personal loan is a loan between a bank and a person, who’s known as an applicant or borrower. Personal loan amounts usually range from $2,500-$35,000 or higher, sometimes up to $100,000, have a fixed interest rate and require only one monthly payment. Personal loans can be used to consolidate and pay down higher-interest debt or cover unexpected and large expenses. When the borrower applies for a loan, the bank will review the application and the person’s credit report, and may review other financial information and have other criteria to review for verification, before making a decision. This process is called underwriting. During the underwriting process, the bank will review all details of the application, such as a person’s credit history, job history, income, and assets. If the application meets or exceeds what the bank is looking for, the loan may be approved.

Personal loans and other unsecured loans, can be a nice option to borrow smaller amounts of money at a fixed rate. Personal loan amounts may be $35,000 or less, versus a secured home equity loan, which may be more than $35,000 and potentially up to $150,000. Secured loans could include mortgages and home equity loans. Secured loans are a good option if you are looking to borrow a larger amount of money, want longer repayment terms and are seeking a lower interest rate and willing to put up collateral.

6. Amortization

Amortization is the process of paying down your loan balance over time. In the beginning, a small portion of the monthly payment goes toward principal, with the rest to interest. As the payments continue to pay down 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

People can find themselves with more debt than they are comfortable with if they’re not able to pay off monthly balances in full or if circumstances, such as unexpected major expenses create outstanding bills that go unpaid past the due date, potentially incurring charges and fees. It can add up or spin out quickly if you’re not careful.

There are many ways to pay off higher-interest debt. One simple and easy way you might pay off your debts sooner is to combine them into one payment at a lower interest rate with a debt debt consolidation loan. This loan consolidates multiple bills into one, with your only responsibility being to repay the loan with a simplified fixed monthly payment. Some lenders—like, for example, Discover Personal Loans—can pay your creditors directly.

8. Refinancing

Borrowers can sometimes refinance their loan, meaning apply to get better terms on their current loan. Those that improve their financial standing and have a good history of paying back the loan may have the opportunity to refinance, depending on the lender. Refinancing involves replacing your current loan with another loan. The new loan can come from the same lender or another bank. This could result in lower payments, lower interest rates or a shorter term, depending on the borrower’s situation and the interest rate they can be approved for.

Let’s say you took out a personal loan two years ago. Since then, you’ve made on-time payments every month, plus you paid down your credit card debt. Your credit profile has improved over the last 24 months. It’s possible that your healthier credit history will now allow you to get better loan options, either from your current lender or from a new lender.

9. What is a Credit Report?

A credit report is an in-depth history of your borrowing habits and actions. When you borrow money from a bank or have an open credit card, they report information to the three major credit bureaus. 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.

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.

Additionally, the actions you take when you have secured a loan, such as paying on time, are reported back to credit bureaus. Ensure you can make the monthly loan payments in full before you agree to take on the loan and monthly payment amount.

You are entitled to a free copy of your credit report each year from all three credit bureaus. To receive your copy, go to AnnualCreditReport.com.

10. What is a Credit Score?

Credit scores factor in your payment history, amounts owed, mix of credit types, length of credit history, and new credit.

Having a healthy credit score matters because many lenders consider it in loan applications. Therefore, it’s important to monitor your credit score so you can notice if it changes dramatically, which could indicate an inaccuracy in your credit report that may be bringing your score down. The healthier your credit score, the greater chance you may have of being approved for a loan.

Keep in mind that sometimes just applying for a loan, with a hard credit pull, can impact your credit score. However, some lenders allow consumers to check their loan interest rate without actually applying for the loan and without any ding to your credit, using what’s called a soft credit pull. Checking the loan interest rate before applying allows the consumer to make a more informed decision before locking into a loan.

Share this Image On Your Site