Making Borrowing Decisions

A loan is a form of debt where one party agrees to lend money to another with an agreement to pay it back.

Debt is the total amount of money you owe to another party. Debt covers any amount owed to another, whereas a loan refers to an agreement where one party lends to another. (e.g., assume you have a student loan and an auto loan. Your debt is the sum of these two loans).

Components of a Loan

In addition, the lender may charge additional fees, such as an origination fee, servicing fee, or late payment fee.

When discussing loans, it is essential to recognize the components of typical loans.

Principal

This is the original amount of money that is being borrowed.

Loan Term (or repayment period)

The amount of time the borrower has to repay the loan.

Interest Rate

The rate at which the amount of money owed increases is usually expressed as an annual percentage rate (APR).

Loan Payments

The amount of money that must be paid every month or week to satisfy the loan terms.

Types of Loans

Loans fall into two categories: unsecured and secured.

Unsecured Loan

Requires no collateral. These usually have higher interest rates than secured loans because they are riskier for lenders (e.g., personal loans).

Secured Loan

Uses an asset you own as collateral; the lender can take the asset if you do not repay the loan (e.g., auto loan, mortgage, home equity loan).

Most Common Loans Used in Our Daily Lives

Personal Loans

A personal loan is a type of loan that allows borrowers to borrow a lump sum of money they can repay over time in monthly installments. Personal loans are typically unsecured, meaning borrowers do not need to put up any collateral to qualify for the loan. This makes them a flexible option for borrowers who need cash for various purposes, such as consolidating debt, paying for unexpected expenses, or making a significant purchase.

Personal loans can be found through various lenders, including banks, credit unions, and online lenders. The interest rates and terms of personal loans vary depending on the lender, so it is vital to shop around before you apply. To learn more, visit What Is a Personal Loan?

Auto Loans

An auto loan is a secured loan used to purchase a vehicle. When you take out an auto loan, the lender gives you the money to buy the car, and the vehicle itself becomes collateral for the loan. If you default on the loan, the lender can take the vehicle back to recoup their losses.

Auto loan terms typically range from 36 to 72 months, and the interest rate on an auto loan is typically lower than the interest rate on a credit card. This is because auto loans are considered lower risk since the lender has the car as collateral.

When you take out an auto loan, you will make monthly payments to the lender. These payments will include both the loan's principal amount and the interest charged on the loan. The amount of your monthly payment will depend on the terms of your loan, such as the loan amount, the interest rate, and the loan length.

Making all of your auto loan payments on time is essential, as missing a payment can damage your credit score. If you cannot make a payment, you should contact your lender as soon as possible to discuss your options.

Student Loans

A student loan is a type of loan used to finance the cost of post-secondary education and the associated fees, such as tuition, books and supplies, and living expenses. Student loans can be federal or private and have various terms and conditions.

The U.S. Department of Education offers federal student loans, which typically have lower interest rates and more flexible repayment options than private student loans. Some benefits of federal student loans include deferment, forbearance, and income-based repayment options.

Banks and other financial institutions offer private student loans. They typically have higher interest rates than federal student loans, but they may offer more flexible repayment options.

Mortgages

A mortgage is a loan used to purchase a home. The property that is being purchased acts as collateral for the loan, which means that if the borrower defaults on the loan, the lender can take the property back.

Mortgages are typically repaid over 10, 15, 20, or 30 years. The interest rate on a mortgage can be fixed or adjustable. A fixed-rate mortgage means that the interest rate will stay the same for the entire life of the loan. An adjustable-rate mortgage means the interest rate can change over time based on market conditions.

The amount of money a borrower can borrow for a mortgage will depend on their income, credit score, and other factors. Borrowers will also need to make a down payment on the property, which is typically 20 percent of the purchase price.

Mortgages are a significant financial commitment, so shopping around and comparing rates before choosing a lender is essential. You should also ensure that you understand the loan terms before you sign any paperwork.

Home Equity Loan

A home equity loan is a type of loan that allows homeowners to borrow money against the equity they have built up in their homes. The loan amount is typically limited to 75 to 80 percent of the home's appraised value, and the loan terms can range from five to 30 years.

Home equity loans are often called second mortgages because the borrower's home secures them. If the borrower defaults on the loan, the lender can foreclose on the home and sell it to repay the debt.

Home equity loans typically have fixed interest rates, which means that the borrower will pay the same interest each month over the life of the loan. This can make it easier to budget for the loan payments.

Home equity loans can be used for various purposes, such as home improvements, debt consolidation, education expenses, medical expenses, and retirement savings.

Before taking out a home equity loan, it is essential to compare interest rates and terms from different lenders. You should also make sure that you can afford the monthly payments.

Credit Builder Loans

Credit-builder loans are a type of loan that can help borrowers with low or no credit scores build their credit history. These loans typically have a small amount, such as $300 to $1,000, and a fixed monthly payment term of 6 to 24 months.

The borrower makes monthly payments to the lender, and the lender reports these payments to the credit bureaus. This shows lenders that the borrower can make on-time payments, which can help improve their credit score.

Credit-builder loans can be a good option for borrowers looking to improve their credit score but do not have a lot of credit history. However, it is important to note that these loans may have higher interest rates than other types of loans.