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How do loans work?

Loans can be the answer when you need money to buy something big or cover an unexpected expense. But exactly how do loans work? Banks, credit unions and other lending institutions have so many types, and the words used to describe them typically aren't familiar to anyone but the lenders themselves.

The good news is you don't need a degree in business or finance to understand the basics. This guide will give you all the info you need to understand loan officers and choose a loan like a pro.

How does a loan work? The basics you need to know

There are many kinds of loans, but they all work basically the same way. Here's how:

  • A loan is an agreement with a lender. A loan is an agreement where a lender gives you money, and you say you'll pay it back within a given period like 12 months or 5 years. This is the term of the loan.

  • With many loans, you get to pay the money back over time with multiple payments. What was a large amount of money gets broken down into smaller, more manageable chunks, aka your payments.

  • To get the benefits of a loan, you agree to pay more than what you borrowed. The lender adds a certain percentage to your balance each month.

  • The amount you borrowed is the loan principal. The extra added by the bank is interest. Lenders determine both the interest rate you pay and an annual percentage rate (APR). APR includes the annual interest charged and the other additional fees and costs required to get a loan, and provides an easy way to compare costs of different loans.

  • An interest rate can be fixed, meaning it stays the same the whole time you pay a loan. Or, it could be variable. A variable rate may change on a set schedule or when things happen in the economy, like when the Federal Reserve raises rates.

  • Lenders take on a risk when they provide loans. If the borrower doesn't pay, they could be out the money.

  • To protect themselves, lenders are choosy about who gets loans. They might use your credit rating, credit history, income, and other factors to determine how likely you are to pay the loan back. The process of evaluating borrowers is called underwriting.

  • If the underwriter thinks you're likely to repay, your loan will be approved. If not, the lender will decline your application.

  • Borrowers who seem riskier may get approved but at a higher interest rate or for a smaller loan than others. Each lender has its own rules and standards for underwriting. That's why it's worth considering multiple lenders.

What types of loans are available?

Now that you're a master of loan basics, you're ready to explore the different types of loans lenders offer. Remember not all lenders offer every type.

There are two main kinds of loans:

  • Secured loans

    require you to back up your loan with something of value called collateral. If you don't pay your loan, the lender can take the item to get their money back. Because they're less risky, secured loans usually have lower interest rates and can be slightly easier to get.

  • Unsecured loans

    don't have any collateral. Lenders usually charge more for them, and you usually need a higher credit score and more income to get them.

The most common types of loans include:

  • Business loans:

    Apply for these to start a business or get money to grow one. Some are secured by stuff you won or are buying, such as equipment. Others are unsecured.

  • Student loans:

    These loans pay for higher education, including a 4-year school or trade school. Banks offer different student loans for undergraduate and graduate students. Plus, some have loans for parents.

  • Car loans:

    Get one of these when you're in the market for a new set of wheels. The bank will secure the loan with the vehicle title, so they can repossess the car if you don't pay.

  • Home loans:

    Use one to purchase a new home or make improvements to an existing one. Normally, the deed for the home becomes collateral for the loan. If you don't pay, the bank can seize the house and sell it to recoup the money.

  • Personal loans:

    If one of the above doesn't cover you, a personal loan is likely what you need. You can use one to pay for a vacation, a wedding, or other major expenses. Most personal loans are unsecured.H2: What's the process for getting a loan?

What's the process for getting a loan?

Although lenders may have different systems, you normally take the same basic steps to get any loan. Let's walk through the process step by step, so you know what to expect.

1. Application

The first step to getting a loan is completing an application. Some lenders require you to come into a branch to apply. Others offer online and phone applications.

No matter how you apply, you're going to need some basic information. Before you stop in, call, or click, gather the following:

  • Social Security number or tax identification number for a business loan

  • Driver's license or state-issued ID number

  • Employer name, address, and phone number

  • Recent pay stub or tax return if you're self-employed

  • Vehicle identification number (VIN) of the vehicle for a car loan

  • List of bills you pay, such as rent and utilities

  • Statements for any bank accounts or investments in your name

You might not need all this information, but having it will save you time. When filling out an application, answer as honestly as you can to avoid processing delays.

2. Underwriting

Once you submit your application, an underwriter takes over. "Underwriter" is just a fancy title for the person who pulls your credit report, checks your credit score, and plugs all the information into a computer. Today, some of this may all happen automatically when you submit an online application. Either an underwriter or a software program generally takes this information to rate your level of risk. It may be through a predetermined algorithm, or it may be more manual, based on the lender’s rules.

In some cases, the underwriter might request more information about you. They may want a copy of a pay stub or want to know about an item on your credit report.

If your loan will have collateral, the underwriter will also take steps to find out the value of the item. They could pull vehicle records for a car loan or order a professional assessment called an appraisal for a home loan.

Normally, lenders will let you borrow up to a certain percentage of the value of your collateral. They call this the loan to value (LTV). If the LTV is 90% and your home is worth $100,000, you could borrow up to $90,000.

How long underwriting takes varies. Lenders may tell you within a day or two if you're approved for an unsecured loan. For secured loans, underwriting may take a few days or even weeks.

3. Disbursement

If your application gets approved, you will need to sign a loan agreement or contract, possibly with an electronic signature. It's usually a long document, but this isn't the time to skip the small print. Read everything, and ask lots of questions.

After you've signed on the dotted line, the lender will disburse the loan. In other words, it's money time, y'all. You may receive a check or direct deposit into your account. Or, you could specify to have the money sent somewhere, like an auto dealership or a mortgage title company, so you can fund a big purchase ASAP.

The time it takes to get your money varies. Some online loans can be instant, whereas others can take a few business days. Your lender should tell you exactly when disbursement will occur.

4. Payment

Good news/bad news time. The good news is that you now have money. The "bad" news is that it's time to start repaying it. The loan agreement will tell you your payment amount and due date. You'll need to pay on schedule to avoid fees and any negative reports to the credit bureaus.

Remember, your payments will likely be split between tackling interest and fees and knocking down the loan's principal.

5. Refinancing

Step five is optional. Many people simply pay off their loans according to the agreement, but others may want to refinance at some point. Refinancing means replacing your existing loan with a new one that has different terms.

Normally, you refinance to improve things for yourself. You may take out a loan with a longer term to reduce your monthly payment. Or, you might take advantage of a change in your credit score and refinance for a better interest rate.

It's important to consider whether refinancing makes financial sense. You may have to pay fees like a prepayment penalty on your old loan or an origination fee for the new one, and your credit score may decrease given that your new lender will run a hard credit inquiry. In cases where you refinance for a longer term loan, the benefit of smaller monthly payments may be outweighed by the fees or paying more interest in the long run.

Some lenders will offer incentives to refinance and keep your loan with them. You're free to look around and refinance with a different lender if you wish. You never know when comparison shopping might pay off.

Fees to keep an eye out for

Interest is the main way that lenders make money on loans, but fees also provide a source of revenue. Application fees, origination fees, processing fees, annual fees, late fees, and prepayment fees may come into play. Be sure to ask if you'll be responsible for paying any of them so you don't end up unexpectedly on the hook.

What is an application fee?

You pay this when you apply for a loan. Not all lenders or all types of loan come with an application fee. When it does, it's usually a flat amount that covers the cost of underwriting, which may be $25 or $50. Normally, you don't get it back even if the lender declines your application.

What is a loan origination fee?

You would pay this fee on an approved loan as a percentage of the total amount borrowed, which could be 1%, for example. It pays for getting the loan documents drawn up. Not all lenders or all types of loan come with an origination fee. Normally, you see origination fees with complex loans such as mortgages.

What is a processing fee?

A processing fee is another way for lenders to pay costs associated with processing. Like a loan origination fee, it's usually a percentage of 1.5% or 2% of the total loan value. Normally, you don't pay both a loan origination and a processing fee on the same loan.

What is a late fee?

A late fee is what you pay when you don't make your payment on time. It may be a flat fee or a percent of the monthly payment amount.

Most lenders do give you a grace period of a couple days. If you pay within it, you may avoid a fee or pay a smaller one.

What is a prepayment fee?

When you take out a loan, you agree to have the whole thing paid off on a certain date. The lender can then anticipate that they will earn a minimum amount of interest based on the loan term.

If you pay a loan off early, you may save on interest, meaning the lender makes less than they expected. To offset that, the financial institution may charge you a prepayment fee for your early payoff.

Not all loans have prepayment fees, and are less common than they used to be, but you may see them on car loans or mortgages.

Answers to your other burning questions about loans

Got more questions about loans? We have answers.

What is a lump sum?

A lump sum refers to the full payment made at one time. The opposite of a lump sum is an installment, a smaller payment you make multiple times to equal a total value.

The loan disbursement made by your lender is usually a lump sum. You generally repay the loan in installments.

How do I choose the right loan?

There is no single best loan for everyone. To choose the best option for you, consider:

  • Interest rate & APR:

    How much extra will you need to pay for your loan?

  • Fees:

    How much extra cost do fees add to your payments?

  • Term:

    How long will you be paying off the loan?

  • Payment amount:

    Can you afford the monthly payment?

  • Fixed vs. variable:

    Will your loan payment always be the same? If it can go up, is there a maximum amount it can reach? Could you afford to make the largest possible payment?

  • Lender reputation:

    What kind of reviews does the lender have online? Do you find any negative news articles when you search their name online?

What happens if I pay more on my loan?

Feeling flush? Lenders may apply overpayments to the extra balance to the principal, reducing the total amount of money that you owe. Or, they may just use the extra dough to cover future payments. You may need to clearly instruct your lender how you want the additional payment to be applied.

Making larger payments will usually pay off your loan sooner. In some cases, you may end up paying less in interest as a result. Remember that you could also end up slapped with a prepayment fee, so double-check your loan terms before you use your work bonus or lottery winnings to wipe out a loan.


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