« Learn about Lending & Borrowing

How Loans Work

A loan is a sum of money that you borrow from another individual or organization; often a bank or credit union. When you take out a loan, you agree to pay back the loaned amount at a specific date in the future or over a series of separate payments. Some loans come with interest to be paid in addition to the principal amount, while others carry no interest. If a loan has zero interest you do not have to pay back any additional money beyond the original loan amount. By acquiring a loan you go into debt. You remain in debt until you repay the entire value of the loan plus any interest owed.

Getting A Loan

Before getting a loan you need to carefully consider your current financial situation. It is essential to determine your monthly obligations, the loan terms, the duration of the loan, and how a missed payment could affect you.

This is often helpful in picking the best kind of loans and prevents individuals from securing bad loans. You need to ensure that the repayment plan is one you can adhere to. Otherwise, you risk losing your collateral, in the case of secured loans, or damaging your credit score in the case of unsecured loans.

Loans can be tricky to navigate, so it is important to ask questions and clarify vague parts of the loan terms. In addition, you can check with different providers to determine which one provides the best interest rates and payment plans that fit into your budget.

Secured Vs. Unsecured Loans

You may have heard of the term "secured loan." There are various types of loans offered by many different sources. Sometimes loans have to be secured. This is where collateral is used as a means of securing your loan. If you default on the loan, the lender can take your collateral and sell it to recoup their money. An example of a secured loan is a mortgage, where the borrower is collecting a loan against the equity on their home. On the other hand, loans can also be unsecured. Credit cards are an example of an unsecured loan. A lender will usually provide a credit card to a borrower based on their past credit history. This is where having a good credit scores comes in handy.

Types Of Loans

It is important to know the type of loan you are getting when securing a loan. Armed with this information, you can make informed decisions about the best type of loan for your situation. Some loans are better than others depending on your needs. This article will focus on the different types of loans available to you.

Personal Loans

A personal loan is perhaps the most common type of loan on the list. These are used in everyday lives by individuals to facilitate daily living. Personal loans can cover a broad range of situations where extra money might come in handy. You can take out personal loans for minor or major purchases, vacations, weddings, and so on. These loans are typically available from banks and credit unions. Smaller financial institutions are also known to offer personal loans.

Personal loans can also be used to pay off other debt. Depending on your credit score, a personal loan may carry lower interest rates than a credit card loan. If you have existing credit card debt which you are paying high interest rate on, you may be able to take out a personal loan with a lower interest rate, use the personal loan to pay off the credit card debt, and then begin paying off the personal loan at a lower interest rate.

Personal loans can also come in handy with financing significant projects. A personal loan can be a good choice for home renovations, relocations, medical emergencies, or big purchases like furniture and electronics.

Secured Vs. Unsecured Personal Loans

It is important to note that personal loans can rely heavily on credit scores, especially unsecured personal loans. Secured loans, on the other hand, allow you to secure a loan against assets such as property. Secured personal loans generally offer better interest rates compared to unsecured personal loans, and they also allow higher loan amounts.

Getting a personal loan is a relatively straightforward process. An excellent credit score will put you in a position to get the lowest interest rates for your loan.

If you already have a low or bad credit score, you may be denied a personal loan. For those with a good credit score, a personal loan can be a great choice. With a bad credit score, a secured personal loan may be the only option available.

Personal loans can be secured through banks, credit unions, and money lenders. Flexible repayment plans can be agreed upon between you and your lender.

Home Equity Loans

A home equity loan is another type of secured loan. To be approved for a home equity loan, you will use your home as collateral for the loan. A home equity loan will allow you to borrow against the amount of equity in your home. With a fully paid-off home, you can borrow up to 100% of the value of your home. However, if mortgage payments are still being made on your home, then you can only borrow up to the amount you have paid off. If 80% of the home is paid off, then the lender will provide a loan up to 80% of the home's value.

Home equity loans carry lower interest rates compared to their counterparts. However, it comes down to your risk appetite as the borrower. If you are unable to pay back the home equity loan, you run the risk of losing the home that you used as collateral.

You should keep in mind when pursuing a home equity loan that the value of the home can go up or down. In case of default due to lack of income in an economic crisis, the lender can claim your home to cover the debt.

Student Loans

Student loans are available to students who wish to pursue higher education but cannot afford them. These loans are repaid after the student completes their education and begins working. Interest rates on these loans vary largely depending on where the loan comes from. Individuals can get students loans from the federal government or via private student loan providers.

Federal Vs. Private Student Loans

The major difference between federal and private student loans lies in the interest rate. Federal student loans can offer 0% interest rates depending on the economic situation of the country. A typical example is the COVID-19 pandemic which sent many countries into lockdown. During this time, the interest rates on federal student loans were reduced to 0% in many cases.

Student loans are generally long-term loans. As such, the repayment period is often as long as 10 to 25 years. Additionally, loan forgiveness is often impossible with private loans, while federal student loans can qualify for loan forgiveness.

Mortgage Loans

You should consider a mortgage if you are looking to purchase a property. It is a secured loan, meaning that if you default on your payments and the bank repossesses the house, then the bank will be able to make up for your unpaid loan.

Since mortgages are considered secured loans, they carry low-interest rates. It is also often a long-term loan with a repayment time frame of 15 to 30 years. The loan is paid gradually over the years through monthly fixed payments agreed upon between the borrower and the lender.

Mortgages are a type of loan where your credit score matters greatly. If you do not have a good credit score, then it is very unlikely that you will obtain a favorable mortgage loan.

Mortgages are not only for purchasing property. They can also be used to obtain a second property, such as a vacation home. Mortgage loans can also be used to refinance an existing loan or to purchase a new home.

Mortgages are among the most common types of loans offered by national banks, national credit unions, community banks, and online lenders.

Small Business Loans

The advent of social media has come with a marked increase in small businesses worldwide. Sometimes these small business owners can fund their businesses with their savings or investment from friends and family. Other times, individuals may have to take loans to set up their small businesses. This is where small business loans come in.

Applicants can get small business loans from most national and community banks through the Small Business Administration (SBA). Applicants will need to submit a business plan or proposal for the lender to review before they can be approved for a small business loan. The lender has the discretion of determining if a business plan is viable to approve the loan.

Small business loans can also be classified as long-term loans, as repayment periods can last five to 25 years. Applicants are required to provide personal guarantees that the business is being used as collateral for the loan. Small business loans also do not have a set range of interest rates as they can be negotiable by the applicant.

Payday Loans

Payday loans are another common type of loan used frequently by consumers. These loans are also called cash advances or check advances and they are very popular among the working class. Payday loans are unsecured loans that can be accessed easily. These loans usually carry a high-interest rate and require the borrower to agree to repay the loan from their next paycheck. This can be in the form of a postdated check or giving the lender rights to withdraw the owed amount from the next paycheck with the agreed-upon interest rate.

Payday loans usually come in handy when a person may need a small amount of money quickly. The most common scenarios where payday loans are used are when people run out of money before their next paycheck arrives. They could need money to purchase groceries, gas, pay a bill, or any small but urgent need.

Payday loans feature much higher interest rates than personal loans. Interest rates on these loans can go as high as 400%, although the amounts borrowed are usually limited to $500 or less at a time.

These loans are often referred to as predatory due to their extremely high interest rates, which is why they are banned in some jurisdictions. Other states have strict regulatory guidelines for payday lenders to protect borrowers from being exploited.

Pawn Shop Loans

Similar to a payday loan, a pawn shop loan is another option for individuals to get quick loans. However, instead of borrowing against their paychecks, borrowers have to provide valuable items to the pawnshop owner in exchange for a fast loan.

In a way, pawnshop loans work similarly to secured loans. The borrower brings in a valuable item, say a piece of expensive jewelry, artwork, or electronics, and the pawnshop lends them money. The borrower then has to repay the loan to the pawnshop in the specified amount of time, or the pawnshop can sell their valuables to cover the cost of the loan given.

Pawnshop loans also feature high-interest rates like payday loans. One unique thing about pawnshop loans is the interest rates are dependent on each pawnshop. The pawn shop will hold on to the item until the total amount is repaid, along with interest.

Borrowing From Family & Friends

Loans from family and friends are arguably the most common type of loan. These loans can range from small amounts to large sums of money. Oftentimes, friends and family will not require interest on the loans they provide to their loved ones. However, there are also instances where family and friends could ask for interest on a loan.

These types of loans are informal with no written contracts. Hence, the chances of default on the part of the borrower are high. This is why signing a promissory note is important when borrowing between friends and family. The promissory note will help to keep both parties accountable and serve as proof in the case of any misunderstanding.

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