The term loan refers to a type of credit vehicle in which a sum of money is lent to another party in exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest and/or finance charges to the principal value which the borrower must repay in addition to the principal balance. Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms including secured, unsecured, commercial, and personal loans.Investopedia
It is quite important to understand loans. Before you take out your first or next loan, get to know the key terms and the implications of the same. Avoid getting into unnecessary debt.
Loan Details and Key Terms
These are the terms you’ll encounter with every loan:
- Principal. This is the portion of your monthly payment that goes toward paying off the amount of money you borrowed. You can choose to pay the exact amount of the monthly payment or more to decrease the amount owed.
- Interest. This is the portion of your monthly payment that is the “cost of borrowing.” It’s figured based on the interest rate of your loan.
- Interest rate. Interest rate is the annual cost of a loan to a borrower, expressed as a percentage, and does not include any additional fees. Interest rates can be variable or fixed.
- Variable interest rates will periodically go up or down throughout a borrower’s loan term according to the rates in the market. Borrowers with variable-rate loans should know, and be comfortable with the fact, that their total monthly payments and total cost of their loan can increase.
- Fixed interest rates stay the same for the course of a borrower’s loan. Borrowers will have peace of mind knowing they will make the same payment every month until their loan is paid off.
- APR. Annual Percentage Rate is the interest rate plus additional fees. The APR is typically higher than the interest rate and gives a more comprehensive view of the actual cost of the loan.
- Monthly payment. This is the amount you’ll pay your lender each month to repay your loan. A portion goes toward principal and another portion toward interest.
- Loan term. This is the length of your loan, usually expressed in months. It’s also the number of payments you’ll make to repay your loan if you don’t repay your loan early.
- Short-term loans are generally loans with repayment terms of one year or less.
- Long-term loans are those with repayment terms of more than one year.
- Security or Collateral. There are two types of loans: secured loans and unsecured loans.
- Secured loans are loans that have some sort of property (also known as collateral) behind them. If you stop paying a secured loan, the collateral can be repossessed. Auto loans and mortgages are two common examples of secured loans.
- Unsecured loans are those with no underlying collateral. A borrower’s good credit is the only guarantee to the lender that the borrower will satisfactorily repay the loan.
- Total loan cost. This is the total amount of money you’ll repay the lender based on the amount you borrow and your interest rate. To compare loans side by side, you can ask lenders for a summary showing the total cost of the loan if paid off according to schedule. You can then see which loan has a lower cost. Keep in mind that loan costs can rise or fall for loans with variable interest rates.
- Maturity Date. This is the date the borrower’s final loan payment is due, the principal is paid to lender, and interest payments are no longer due.
Loan Fees and Penalties
How do loans work? In addition to the terms above, loans often have fees and penalties.
Here are some common loan fees you might be charged:
- Origination fee. Commonly seen with mortgages and mortgage refinances, this is a fee charged by the lender to create your loan. It’s usually calculated as a percentage of the total loan amount.
- Application fees. This is a fee a lender might charge you to apply for a loan.
- Credit report fee. Lenders may charge you for the cost of pulling your credit report during the loan application process.
- Prepayment fee. Some loans come with prepayment penalties if you choose to pay off your loan early. These must be clearly stated in your loan contract, are generally a percentage of your loan amount, and can be quite hefty.
Lenders may charge a late fee if your payment isn’t made on the due date. You could also be charged an insufficient funds fee if your check doesn’t clear or if your scheduled ACH payment can’t be made.
When you borrow money, your lender will expect you to make your payments on time and have the funds in your account to complete your payments. If you don’t hold up your end of the bargain, you might incur additional fees.