how do loans work
Loans

How Do Loans Work?

Close to 80% of Americans have some form of debt, from credit cards to mortgages and personal loans. However, the terms of the loans vary for everyone. The type of loan, your credit score, and many other factors influence your ability to borrow money. To avoid borrowing more than you can afford, learn more about how loans work.

How do loans work?

The loan process involves applying for a loan, getting approved, establishing a repayment plan, and paying off the loan. The repayment period may vary from a year to 30 years, depending on the type of loan.

The repayment plan is typically divided into monthly minimum payments. The monthly payments cover interest and principal. The terms of the loan are detailed in a contract signed by the borrower. It is a legal agreement where the borrower agrees to repay the borrowed money plus interest within a specific amount of time.

What are the types of loans offered by banks?

There are two basic types of loans: secured and unsecured loans. Secured loans require some type of collateral. Collateral refers to assets that the lender can seize if you fail to repay your loan. For example, auto loans are often secured by using the vehicle that you purchase as collateral. Home loans (mortgages) are secured by using the home as collateral.

Unsecured loans are loans without collateral, which creates more risk for the lender. Lenders often charge more interest for unsecured loans to offset the risk. If the borrower fails to repay the loan, they may sue the borrower or sell the loan to a collection agency.

Lenders also categorize loans based on the purpose of the loan. Some of the most common categories of loans include:

  • Personal loans
  • Business loans
  • Student loans
  • Home loans
  • Auto loans
  • Other vehicle loans

The most common type of loan is the personal loan. A personal loan may be secured or unsecured. The money from a personal loan may also be used for any reason. According to research completed by PureProfile and Finder, debt consolidation is the most common reason to obtain a personal loan. About 37% of individuals who have taken out a personal loan in their lifetime used the funds for debt consolidation.

Along with consolidating debt, people may obtain personal loans to cover medical expenses, fund renovations, and cover legal fees. Personal loans are also often used for big purchases, such as gifts, vacations, or weddings.

Business loans are used for funding business ventures. They are almost always secured, typically using property or personal assets.

Student loans are used to cover education costs. When obtained through the Federal government, student loans work differently compared to other loans, as students do not typically need to repay the loan until they leave school.

Home loans (mortgages) are almost always secured loans. The home is used as collateral. Auto loans and loans for other vehicles are also typically secured loans.

How do you get the money from a loan?

Disbursement is the process of delivering funds from a loan to the borrower. The funds are typically disbursed to a bank account or sent as a check in the mail.

If you obtain an auto loan, the lender may issue a check that you write out to the dealership. The funds to cover the check come from a new account that you pay down through monthly payments. Some lenders may disburse the funds directly to you. The funds may be deposited in an existing bank account. You then write a check from your account to the dealership.

If you obtain a personal loan, the lender may establish a new account containing the amount that you were approved for. You can then start spending the money as you wish.

How much money do you need to take out a loan?

A down payment is typically only needed for large loans, such as a home loan or an auto loan. You may also need a down payment for an unsecured personal loan. The average minimum down payment for personal loans is about 3% of the loan amount.

Secured personal loans are less likely to require a down payment, as you are using an asset as collateral. However, a large down payment can help you obtain better terms for any type of loan. With a larger down payment, lenders may offer lower origination fees and interest rates.

How do school loans work?

School loans, or student loans, are a type of loan used to cover the cost of post-secondary education, such as attending college or a trade school. Most student loans are obtained through the federal government.

Federal student loans are obtained by completing the Free Application for Federal Student Aid (FAFSA). The application form requires students to supply financial information about themselves and their parents.

The Federal government offers three types of student loans:

  • Direct subsidized loans
  • Direct unsubsidized loans
  • Direct PLUS loans

Direct subsidized loans are used for undergraduate education. The government covers the interest on the loan until the student starts paying back the loan after college. The repayments typically start six months after the student leaves school.

With direct unsubsidized loans, the student covers the interest. The loan begins accumulating interest as soon as the funds are disbursed. However, students and parents do not need to demonstrate that they need financial help.

Direct PLUS loans are loans that parents can take out for dependent children attending undergraduate school.

Students may also obtain private student loans through traditional lenders. Private student loans typically include higher interest rates compared to federal student loans. No matter the type of student loan, students must accept a loan repayment term and interest rate. Most federal loans have a repayment term of 10 years. The average interest rate for a Federal student loan for undergraduate education is about 2.75%.

How is interest calculated on a loan?

Most lenders offer amortized loans, which involve charging interest based on an amortization schedule. The interest rate is divided by the number of payments in the year. The resulting number is multiplied by the remaining loan balance to determine how much interest is charged for the month.

With amortizing loans, the monthly payments are initially interest-heavy. As you pay down your balance you gradually pay less interest. However, the amortization schedule ensures that the amount of the monthly payments remains relatively the same throughout the life of the loan.

Instead of amortizing the interest, some lenders prefer to precompute the interest. They multiply the amount of the loan by the interest rate to determine the total interest charged. The interest is added to the principal and the total is divided into monthly payments.

What is a good interest rate on a personal loan?

The interest rates for personal loans vary widely. The average interest rates are between 4.99% and 36%, according to data from the financial technology company Credible. Other research suggests that the average APR for a personal loan is about 9.34%. Depending on the amount of the loan, your credit score, and the repayment term, an interest of 5% to 10% may be considered good.

How do loans impact your credit score?

Applying for a loan can temporarily lower your credit score. Lenders may perform soft credit checks or hard credit checks. Soft checks are typically used when you request a quote for a loan or use online services to compare rates from multiple lenders. Background checks also typically result in a soft credit check.

According to experts at Credit Karma, soft credit checks do not hurt your credit score. However, a hard check may cause your score to temporarily drop by several points. Hard checks are typically completed when you formally apply for a loan. Hard checks are more thorough compared to soft checks and stay on your credit report for about two years. Performing multiple hard checks in a short time could have a greater impact on your score.

Applying for a loan may have a minor impact on your credit score. However, failing to make your payments after getting approved for a loan has more of an effect on your credit. A single late payment may cause your score to drop by several points or up to 180 points. The amount that your credit score drops due to a late payment depends on how long ago the payment was missed and the amount of the payment.

Do you need good credit to get a loan?

Your credit score influences your ability to borrow money. Most lenders are less willing to lend money to an individual with bad credit scores. However, some lenders see approving loans for those with bad or fair credit as a business opportunity.

Most lenders use your FICO credit score to assess your risk of defaulting on a loan. FICO scores range from 300 to 850. Here are the typical ratings for FICO score ranges:

  • Bad credit: 300 to 579
  • Fair credit: 580 to 669
  • Good credit: 670 to 739
  • Very good credit: 740 to 799
  • Exceptional credit: 800 to 850

According to Experian, which is one of the three main credit reporting agencies, lenders tend to offset the risk of approving a loan for someone with bad credit by charging higher origination fees and interest rates.

For example, if you have bad credit, instead of denying the loan, the lender may offer a loan with higher fees and interest. Improving your credit score before applying for a loan may increase your chances of approval and lock in a lower APR.

Dave Ramsey, a leading personal finance advisor, offers several suggestions for improving your credit score without taking on more debt. Watch the following video for his advice:

The key takeaway from Dave Ramsey’s recommendations is to avoid taking on more debt. You should also focus on paying bills on time to avoid accumulating more negative marks on your credit report. Paying off additional debt also helps your credit.

Review your credit report at least once per year and before applying for a loan. Look for any inaccuracies and dispute them by filing a dispute with the credit reporting bureaus.

What happens when you stop paying a loan?

You are likely to get charged a fee every time that you miss a loan payment. Some lenders may also charge interest on the late fees. Lenders can also notify credit reporting bureaus of each late payment, which hurts your credit score.

When you miss multiple payments, you are “defaulting” on your loan agreement. According to the US Chamber of Commerce, about 3.39% of Americans default on their personal loans. The loan agreement may specify the number of payments that you can miss before you have defaulted.

For example, your loan may be in default after a single missed payment or several missed payments. The process for dealing with loans in default varies from one lender to the next. Some lenders may send a loan in default to the company’s collections department. The collections department may then attempt to contact the borrower to arrange payments.

The lender may pursue other collection methods if the loan remains in default. If the delinquent loan is a secured loan, the lender may repossess the item used as collateral to secure the loan, such as a car for an auto loan. Lenders may also sell delinquent loans to third-party collection agencies or sue the borrower.

The process for dealing with delinquent loans also depends on the type of loan. For example, students can often arrange repayment plans to deal with late payments on federal student loans.

Are loans a good idea?

Loans can be a good idea for those who can meet the financial obligations of obtaining a loan. If you fail to pay the loan, you risk hurting your credit score. If you default on an auto loan or a home loan, you may lose your car or home.

Before applying for a loan, you should determine if it is the most affordable way to meet your financial needs. Along with loans, you should explore potentially cheaper alternatives. For example, if you have excellent credit, you may qualify for a 0% APR credit card. Some employers may also offer cash advances with no additional fees.

If a loan remains your only financing option, try to find the lender with the best terms. Getting a loan with a low APR limits the cost of borrowing money.

Final thoughts

Should you obtain a loan? The answer depends on your ability to repay the loan. Lenders assess the risk of an applicant defaulting before approving a loan. Based on your credit history, lenders may offer different interest rates or propose a shorter or longer repayment plan. Always review the terms before finalizing a loan agreement to ensure that the monthly payments fit your budget.

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