What is a loan? All you need to know about how loans work

A loan is a sum of money that you can borrow from a creditor to use for a variety of purposes and you pay it back in monthly installments.

Typically, you can get a loan with several types of lenders including banks, credit unions and online lenders among others. 

In this article

A loan may seem like a simple thing but there’s plenty that goes into getting a loan, finding the right loan and reading all the fine text. Here’s a refresher on how loans work and everything else you need to know about loans. 

What is a loan?

A loan refers to money lent by a credit union, bank, or online lender that you repay in full, with interest, over a term of two to more years. Before taking a loan, you should consider trying to cover your unexpected expenses with your emergency fund. If that is not possible or if you need the loan for non-discretionary purposes, like debt consolidation, a loan may be the right financial tool to use. 

What are the features of a loan?

Loans typically have four primary attributes: interest, principal, monthly payments and term. Getting a good understanding of each of these elements will help you determine whether a loan is a good fit for your needs and if you can afford it.

Interest

The interest rate is a value that refers to the cost of taking a loan. In other words, it is how much you have to repay on top of the principal amount. Lenders decide what interest rate to lend to you based on several considerations, including your credit score, loan type, and loan term. Remember that interest is not the same as the annual percentage rate, or APR, which factors in other costs like origination fees.

Principal

This refers to the total amount of money that you take as a loan from a lender. This amount can be anywhere from $500,000 to buy a new house or $500 for appliance repair.

Monthly payments

Loans are typically paid back bit-by-bit at regular intervals, usually monthly, to the lender. This monthly payment is generally a fixed sum that repeats throughout the loan term.

Term

The loan term refers to how much time you have to pay back the loan in full. Based on the type of loan, the payment term can range anywhere from months to years.

What are the types of loans? 

Broadly speaking, loans can be categorized into two types: secured loans and unsecured loans.

Secured loans

Secured loans are those where the lender provides a physical asset, like a house or vehicle, as collateral to assure the loan’s repayment if you fail to make pre-agreed payments on the loan. The lender decides your interest rate based on the asset, your credit score, and your credit history. Secured loans typically have lower interest rates compared to unsecured loans. Examples of these types of loans include mortgages and auto loans.

Unsecured loans

Lenders who offer unsecured loans estimate your interest rate solely based on your credit score and history. If you don’t repay the loan as agreed, the lender does not have the right to claim any of your assets. What they can do is report the defaulting to the credit bureaus, which will damage your credit score and your chances of getting another loan later. 

Unsecured loans usually have higher interest rates and give out smaller loan amounts compared to secured loans. Examples of these types of loans include student loans, personal loans, or payday loans.

Here’s a quick look at different types of loans along with their terms and interest rates.

Type of loanTypical interest rateTypical terms
Payday loan400%.2 weeks to 2 years.
Personal loan6% to 36%.1 to 6 years.
Auto loan3% to 20%.2 to 6 years.
Student loan1% to 12%.10 years.
Mortgage3% to 5%.15 or 30 years.

How does a loan impact your credit score?

A loan, just like any other form of credit, can have a huge effect on your credit score depending on how you use it. Making payments on time will help you build your credit, while even a single late payment can damage your score if it is reported to the credit bureaus.

Sending an actual loan application will also affect your score. Many lenders permit you to pre-qualify for a loan with a soft credit check, which won’t damage your score. Once it is pre-approved, applying for the loan formally prompts a hard credit check, which usually brings your score down by five points and stays on your credit for up to two years.

How to apply for a loan?

Applying for a loan can be done in a few simple steps. First, you’ll need to pre-qualify with various lenders so you can compare offers. The pre-qualification only takes a few minutes, and you’ll need to provide minimal information like your basic personal details, the purpose for the loan, the desired amount, and preferred monthly payment.

After you narrow down the best option, you’ll have to provide relevant documents for the formal application process. Typically, the documents needed include a photo ID, financial information, proof of employment status, proof of address, education history, and your Social Security number. 

Many lenders now support a completely online application process, so you can easily submit your application through a computer or handheld device. Once your application is approved, the loan amount can be transferred to your account as early as the same day.

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This page is purely informational. Line does not provide financial, legal or accounting advice. This article has been prepared for informational purposes only. It is not intended to provide financial, legal or accounting advice and should not be relied on for the same. Please consult your own financial, legal and accounting advisors before engaging in any transactions.

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