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 lending 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.
Table of contents
1. Term
3. APR (Annual Percentage Rate)
5. Secured vs. unsecured loans
6. Amortization
8. Refinancing
10. Credit score
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 your budget. 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. For example, many personal loans have fixed interest rates and many credit cards have variable interest rates.
Fixed interest rate loans means that the interest rate that will stay the same throughout the life 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.
3. APR (Annual Percentage Rate)
An annual percentage rate is a combination of a loan’s interest charges, including any prepaid interest, plus certain fees that are charged for the loan. APR is expressed as a percentage. The APR allows consumers to compare loan options and lenders to find the lowest overall cost to them as they pay back the loan.
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 each lender may charge you for your loan 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 charge them. Discover® Personal Loans, for example, doesn’t charge prepayment or origination fees.
5. Secured vs. unsecured loans
Loans can be unsecured or secured. Unsecured loans do not require any collateral (e.g. your home or auto) to be put up to secure the loan. 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. This means they are taking on less risk. If you do not repay the loan, the bank can repossess the asset that is securing the loan.
A personal loan is one example of an unsecured loan. Depending on the lender, personal loan amounts can range from $2,000 to $50,000 or more, have a fixed interest rate. and have a fixed regular monthly payment. They can be used for a variety of purposes, including consolidating and paying down higher-interest debt; financing home improve or repair projects; taking that dream vacation; covering larger unexpected expenses; and more. Personal loans generally cannot be used to pay off secured loans or student loans.
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 equal monthly payments. 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 amount of each payment applied to principal increases. 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 fixed monthly payment due on the same day every month. 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 applying for a new loan to pay off an existing loan. 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. 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, credit limits, balance, payment history and minimum payment due.
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 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. Most financial institutions may review your credit report and consider it when they review your loan application.
10. 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 it. If your credit score changes dramatically, this could indicate an inaccuracy in your credit report that may be bringing your score down.