What Is a Loan?

What is a loan?

Most loans typically have a fixed interest rate, although the rate can sometimes be variable or set for a term. The borrower makes payments in regular installments until the loan is repaid. Lenders can grant loans for individuals, two or more borrowers, businesses, and governments. The purpose of a loan is to give the borrower access to the funds they need while allowing them to repay in monthly installments with interest.

Loans are either secured or unsecured. If a loan is secured, it's backed by collateral. If a loan is unsecured, it's not backed by collateral. An example of a secured loan is an auto loan. The borrower may not have the cash on hand to buy a vehicle outright or may not want to use their money for that purpose. So instead, they can borrow the funds and secure the loan with the vehicle. Loans can be for small amounts of money ($500 or less) or very large sums, depending on who is borrowing and what they qualify for. Unsecured loans are generally only offered up to $100,000, while secured loans may be offered for much larger amounts.

How do loans work?

Now that we've answered "what is a loan," let's look at how they work. Loans have four components: principal, interest, term, and installment payments. The principal, interest, and term will determine the amount of the installment payments.

Principal: The principal is the amount you borrow. If you need a loan for $10,000, the principal is $10,000. The lender can forward this amount to you less any fees. Some loans do have fees, and rather than have the borrower pay them out of pocket, the lender usually deducts them from the loan's proceeds. For example, if your loan has an origination fee of 2%, this would be $200 for a $10,000 loan. After the lender deducts the fee, they would deposit $9,800 to you, even though your principal loan amount is still $10,000.

Interest: It costs money to borrow money. Interest is the amount of money you will repay the lender in addition to the principal borrowed. It's expressed as a percentage. Currently, for personal loans interest can be as low as 6.99% and as high as 35.99% for most lenders. Other loan providers grant short-term loans with much higher interest rates, such as payday lenders.

Installment payments: The installment payment is the amount you need to pay back regularly (usually monthly) over a fixed period to pay off the principal plus the interest charged completely.

Term: A loan term is the length of time you have to pay it back. Loans usually have a period of 1-5 years but can be seven years or, in some cases, longer.

What are the different types of loans?

The two most common personal loan types are secured and unsecured. Borrowers can secure a loan by assigning some kind of collateral to the lender. Auto, motorcycle, boas, and RV loans are examples of this. A mortgage is also a type of secured loan. For an auto loan, the vehicle is collateral for the loan. If the borrower doesn't make the payments, the lender can seize the asset and sell it to cover the loan's outstanding balance. Personal loans that are not for a specific purpose, like a vehicle, can still be secured. Lenders will take security for cash, investments, jewelry, art, and other valuables. Securing a loan can result in a better rate for the borrower. When a borrower doesn't qualify for an unsecured loan, the lender might still approve the loan if the borrower can provide collateral.

An unsecured loan is approved without any collateral. The loan is advanced to the borrower, based on their credit score and signature. If the borrower doesn't make their payments, the lender will have a more difficult time recovering their funds than if the loan were secured. Whether a borrower defaults on a secured or unsecured loan it can be costly for the lender.

How do you qualify for a loan?

Lenders can look at several things before qualifying a borrower for a loan, including:
Income: Typically, the borrower needs income which can be from different sources such as employment, pension, or investments. Having ongoing income can give the borrower the means to make their loan payments.
Credit score: Borrowers need to have a credit score that is acceptable to the lender. Different lenders have different criteria regarding credit scores. Some lenders want borrowers to have a minimum credit score of 660 or 700. Others will accept borrowers with a lower score, like 600 or 560.
Debt-to-income: Lenders have a ratio called the debt-to-income ratio. Borrowers can have a maximum percentage of their income to put toward debt repayment. Your debts cannot exceed the debt-to-income percentage with the new loan payment to qualify for a loan.

When is the right time to get a loan?

There's no real right or wrong time to get a loan. Often, people get a loan because they need the money. While this is a common motive for taking out a loan, you should not take the loan if you cannot afford the payments. If you have credit challenges it can work in your favor to improve your credit score before taking out a loan. Having a good to excellent credit score can make the approval process a lot easier and should help you get a better interest rate than if your credit rating is fair or poor. If you check your credit score and there's room for improvement, working to increase it before you get a loan could be beneficial to you. Having stable employment and some savings to make sure you can make your payments will help you manage your financial obligations.

What are the advantages of loans?

If taken and managed responsibly, loans can offer plenty of advantages.
Get the money you need. Sometimes we don't have time to save for something we need. Or perhaps, you have the cash, but prefer to borrow money rather than deplete your savings account. Whatever your situation is, loans can help individuals access the money they need. Loans can help individuals afford expenses such as home or car repairs.Getting a loan can give you the funds you need to do what you want.
Borrowing money can be inexpensive. While you usually have to pay to borrow money, you can find low interest rates that can make borrowing money more affordable. Alternatively, you may even be able to find and qualify for loans with promotional 0% interest periods. Loans can usually be a cheaper option when borrowing money than other credit products.
Fixed monthly payments. Most loans come with a fixed term. Loans that have a fixed term will have fixed monthly payments, meaning they will always be the same until the loan is paid in full. Once the loan is paid in full, you will not be responsible to make any more payments. If you have the choice of a fixed versus variable loan, you should go with a fixed loan when possible.
Increase credit score. Having a loan can help you increase your credit score. For example, if you make your payments on the due date, it will show on your credit report that you are a reliable borrower.

What are the disadvantages of loans?

While there are many advantages of loans, there are disadvantages too.
Interest and fees. In most cases, there will be interest and or other fees associated with your loan. If you have the cash and are comfortable spending it, it can be cheaper than borrowing money.
Monthly payment commitment: Taking out a loan means committing to another monthly payment. The higher your monthly expenses are, the more stressed you may become.
Credit score impact. If you miss payments or default on a loan, it can negatively impact your credit score.

What is the difference between a loan and a credit?

Loans and credit are both financial products, but they work differently.

A loan is a fixed amount of money advanced in a lump sum to the borrower. The borrower uses the money and then pays back the amount borrowed plus interest over a set period with regular payments.

A credit is a lending product like a personal line of credit or a credit card. The borrower has a limit that they access in full, partially, or not at all. If the credit product has a limit of 10K, for example, and the borrower uses 5K, they can still use up to the additional 5K later. If they pay off the 5K they originally borrowed, they will be able to access 10K. Credit typically has higher interest rates than loans and are renewed annually.

Another key difference is how people use loans versus credits. Loans are often used for one-time purchases or events, such as debt consolidation. On the other hand, credit products can be used when people want to do something but don't know how much it will cost, such as a renovation or wedding. In addition, people sometimes use them to cover shortfalls in monthly expenses or keep them in case of emergencies.

How does a loan payment work?

As we saw earlier, loan payments are made up of principal and interest. They are a fixed amount that is payable monthly on a specific date. They are amortized over an agreed-upon term, such as four years, and you'll make those payments until the loan is paid in full. Typically, the lender takes the payments by automatic debit from the borrower's bank account.

Do loans hurt your credit score?

Getting a loan can hurt your credit score a bit in the short term for two reasons.

First, the lender often makes a hard inquiry on your credit report, which will reduce your credit score a bit. Secondly, part of your credit score is calculated by the length of time accounts have been open. Therefore, opening a new account at the maximum limit with no payment history can reduce your score. The good news is that if you make your payments on time, having a loan can help your credit score in the long run.

How do you get the money from a loan?

Lenders have different ways of disbursing loan proceeds. Before you can get the money from a loan, you may need to sign the loan agreement accepting the terms and conditions of the loan. Once that's done, they can fund the loan. If your loan is for something specific like a vehicle, they may make a cashier's check payable to the dealer for the loan amount. If it's for a consolidation loan, they may make payments to all the creditors that you want to pay off. If it's for personal use, the lender could deposit it to your bank account, give you a cashier's check or send it electronically to a financial institution you deal with.

Is taking a loan worth it?

Going into debt is not something to be taken lightly. It will obligate you to make payments and often takes a long time to pay off the borrowed funds. Whether it's worth it or not depends on the borrower's situation. Sometimes people find themselves in urgent situations where they have to borrow money because they need to do something and don't have the cash available. For example, they may need a car for work, pay for medical or dental expenses, travel to see a relative who's ill, or do urgent home repairs. A loan can be a cost-effective way to help resolve an emergency or crisis for the borrower.

Taking a loan for things that are wants but not needs might not be the best choice. Once you have accepted the money, you'll be obligated to make the payments until the loan is paid off. This can take years, cost a lot in interest, and put extra stress on your budget. In addition, if you don't make your payments on time, you can damage your credit score.

Does it hurt to pay off a loan early?

While it may seem strange, paying off your loan can negatively impact your credit. Credit scores are generated by the length of time an account has been open, whether payments have been made on time and the borrower's credit mix. Paying off a loan closes the loan. This means that your credit mix has fewer products, and the account history has been reduced. In addition, credit reports assign a heavier weighting to open accounts rather than closed ones which will also impact your score.

Reducing your debt can be a great feeling, but you might want to consider ways to do it that will boost your credit score. Paying off or reducing credit card balances is a good way to go since the account will stay open, and having your balance less than 30% of the credit card limit will have a positive effect.

Another thing to consider is that your cash might be better kept for emergencies or other purposes than paying off your loan. But, on the other hand, you never know when you might need the money you have saved, and the loan will eventually be paid off if you regularly make payments.

What are good reasons to get a loan?

There are some valid reasons to get a loan. For example, a loan could be a good option if you need the money to address an emergency or acquire something that will help improve your life significantly. If you want to build your credit rating over the long term, a loan can help you do that. Borrowing to increase your earning potential, such as getting a car to get to work or upgrading your job skills, can both be good reasons to get a loan.

How do you apply for a loan?

Most banks, credit unions, and online lenders offer loans. In most cases, there will be some research involved before applying for a loan. You will need to decide what type of loan you need and how much you need to borrow. Once you have determined those details you can move forward and find the best deal. In most cases, you will need to apply by submitting an application to get prequalified for a loan. Once you are prequalified, you should know what a lender can offer. The lender may need you to submit certain documents such as proof of income or identification before granting you pre approved status. If you need a personal loan, you can check offers at Acorn Finance. With a network of top national lenders, you can unlock some of the best personal loan offers on the market without impacting your credit score.