A loan takes place when a lender, like a traditional bank or online lender, extends a set amount of cash to a borrower. In exchange, the borrower agrees to repay the loan at a specified interest rate over the course of a set loan term. Whether you’re considering a small personal loan or a larger loan to purchase a home or vehicle, understanding what loans are—and how they work—can help you save money and frustration.
How Loans Work
In general terms, a loan involves borrowing a lump sum from a lender, and making regular (often monthly) payments until the loan is entirely repaid. Beyond repaying the loan principal, a borrower must pay interest at a set rate as well as any additional lender fees. To understand how loans work, familiarize yourself with some common terms.
Loan principal is the amount of money a borrower agrees to pay back under a loan agreement. In most cases, the principal is equal to the loan amount. However, if a lender tacks on any fees to the principal—rather than subtracting them from the cash disbursement—the principal will be higher than the actual amount borrowed.
Once a borrower begins making loan payments, a portion of each payment goes toward the accrued loan interest, and the lender applies the remaining portion to the loan principal. The minimum monthly payment is what is necessary to pay off the loan principal and interest within the loan term. If a borrower makes any payments beyond the minimum, the lender applies the extra against the principal.
A loan term is the amount of time a borrower has to repay the loan. Also referred to as the term length, the term of a loan depends on the borrower’s creditworthiness and the repayment terms the lender offers. Loans with longer terms are characterized by smaller payments, but the borrower may pay more in interest over the life of the loan.
Personal loan terms typically range from two to seven years, though they may be as short as six months or as long as 12 years. The average term for an auto loan is six years, but they can range anywhere from two to eight years. Student loans are longer, with most lasting 10 years, and mortgages are generally the longest at 15 or 30 years.
Note: “Loan terms” may also be used to describe the terms and conditions of the loan. In this case, loan term refers to characteristics like the annual percentage rate, monthly payment amount, fees, monthly payment due date and term length.
Interest & Fees
The interest rate on a loan is the money the lender charges a borrower for access to the money—or the cost to borrow the money.
Similarly, the annual percentage rate (APR) represents the total annual cost over the life of the loan. This includes the interest rate as well as additional finance charges like closing costs and origination fees. Available interest rates and APRs are often used to advertise loan offerings, so look for the most competitive rates when shopping for a loan.
Personal lenders typically offer rates anywhere between 10% and 28%, but a good interest rate on a personal loan is one that’s lower than the national average of about 12%. Mortgage lenders, on the other hand, typically charge rates between 3% and 8%. That said, the exact rate a lender offers to a borrower will depend on her creditworthiness, the loan amount and other factors that impact the amount of risk borne by the lender.
Additional fees a lender may charge when extending a loan include:
- Application fee. Some lenders charge an application fee to cover the costs of processing the application. However, many lenders offer fee-free loans, so consider this when shopping for a bank or online lender.
- Origination fee. Origination fees cover the lender’s cost of processing applications, verifying borrower income and even marketing its loan products and other services. Personal loan origination fees generally range from 1% to 8% of the loan amount, but fees vary based on factors like the borrower’s credit history.
- Late payment fee. Lenders often charge fees when a borrower makes a late payment or if a payment check is returned for insufficient funds. That said, lenders that offer fee-free loans may not impose these penalties.
- Prepayment penalty. Some lenders also charge borrowers a fee—or prepayment penalty—for paying off their loans early. Prepayment penalty amounts are typically a percentage of the outstanding loan balance and start around 2%. Notably, many lenders choose to remain competitive by skipping prepayment penalties altogether.
Loan repayment is the process of paying back a loan—typically on a monthly or quarterly basis and in fixed payment amounts. A portion of each payment goes toward the interest, and the remaining portion is applied against the loan principal. Payments must be made in accordance with the terms of the loan, as established in the loan agreement.
To qualify for a loan, prospective borrowers must meet certain eligibility requirements that vary by lender. Common qualification requirements include:
- Debt-to-income-ratio. A borrower’s debt-to-income ratio (DTI) represents the amount of income he brings in each month compared to how much of that income is paid toward monthly debt service. Lenders generally prefer borrowers with a DTI less than 36%, but this requirement varies by lender.
- Credit score. Credit scores indicate a borrower’s creditworthiness and signal to the lender whether the applicant presents a high level of risk. A borrower’s credit score is made up of several factors, including credit history, credit utilization rate and credit mix. On average, the minimum FICO credit score needed to qualify for a loan is between 610 and 640; applicants with scores above 690 are more likely to qualify for competitive rates.
- Income. Like DTI, income demonstrates a borrower’s ability to repay a loan. While some lenders publish minimum income requirements, others prefer to evaluate the sufficiency of a borrower’s income on a case-by-case basis. Minimum income requirements vary by lender and many lenders don’t publish them.
- Stable employment. Stable employment signals to a lender that a borrower is likely to have a sufficient income into the future.
Types of Loans
In general, a loan may be secured or unsecured, meaning that you may be required to pledge a valuable asset to collateralize the loan. Likewise, loans may be classified as revolving, if funds can be accessed on a revolving, as-needed basis; or term, where the loan is disbursed in a lump sum and repaid over a set period of time.
Secured vs. Unsecured Loans
Secured loans are collateralized by something of value—like a home or vehicle. If the borrower defaults on the loan, the lender can foreclose, repossess or otherwise seize the collateral to recoup the outstanding loan balance. Because these loans pose less risk to lenders, they are typically characterized by lower interest rates.
Auto loans and home mortgages are common examples of secured loans, but lenders may also extend personal loans secured by assets like a savings account, certificate of deposit or vehicle.
Unsecured loans, on the other hand, do not require the borrower to pledge any collateral. Here, the lender cannot seize underlying assets in the case of borrower default. For that reason, interest rates tend to be higher and qualification requirements more stringent. Common examples of unsecured loans include credit cards, student loans and most personal loans.
Revolving vs. Term Loans
When borrowers get a term loan, they get a lump sum payment upfront and pay it back through set payments over a specific period of time. Loan repayment terms generally range from two to seven years, with longer terms available to more creditworthy borrowers. In general, borrowers must pay interest on the entire loan amount at a fixed or variable rate.
With a revolving loan, or revolving credit, the lender extends a line of credit with a set borrowing limit. The borrower can access those funds on a revolving, as-needed basis and only pays interest on the outstanding balance.
When Is the Right Time to Get a Loan?
A loan may seem like your best—or only—option, but there are certain circumstances where loans make more sense than alternatives like a credit card or home equity line of credit (HELOC). Where possible, avoid taking on new debt unless you have a high credit score and can fit a new loan payment into your budget. If your finances are in shape, consider these situations where a loan might be appropriate:
- Home improvements. Home improvements can range anywhere from a few hundred dollars to tens of thousands of dollars. A personal loan or home equity loan can be a great way to finance larger projects—especially if you qualify for a low interest rate. However, if you think your project and expenses will be spaced out over time, consider a HELOC so you only pay interest on the credit you access.
- Consolidation of high-interest debt. If you have several outstanding loans or credit cards, a lower interest loan can help you consolidate the balances and streamline payments. Using a debt consolidation loan also may lower your overall interest rate, and can lower your monthly payment amount by extending the loan term.
- Large purchases. A loan may be a feasible option if you need to make a large purchase and don’t have the necessary cash on hand.