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The Lowdown on Loans
The Basics
At the most basic level, a loan is a form of credit where a lender gives a specific amount of money to a borrower, with the agreement that it will be paid back later, typically with interest.
People borrow money for many reasons, from purchasing a home to buying a car or to cover emergency expenses. But, before you take out that loan, consider the way borrowing may impact your finances and get advice from a financial advisor to help you sort out the pros and cons.
Some Key Words to Know
Loan Terms – All the agreed upon details of the loan including how much the borrower pays each month, the interest rate, and how long the borrower has to pay back the loan.
Term of Loan – The length of time it takes to repay the loan.
Principal – The amount being borrowed, which does not include any interest or fees.
Interest – The amount charged to be able to borrow money, listed in dollars.
Interest Rate – The amount charged to be able to borrow money, listed as a percentage.
APR – Annual percentage rate (APR) is the total amount the lender charges for the loaned money, including the interest rate and fees.
Down Payment – Money a borrower pays out-of-pocket to the seller towards the purchase price of the item being borrowed against, which will reduce the principal amount of the loan.
Payoff – Paying the remaining loan balance, including interest, principal, and fees.
What You Should Consider
Before you think about getting a loan, be sure to evaluate your current financial situation. Because, if you aren’t careful, you could end up putting yourself in debt that you can’t pay back. Next, don’t go with the first bank you find – compare different lenders, do your homework, ask questions, and your future self (and wallet) will thank you.
Interest Rates
Interest rates play an important role in determining how much you pay back each month.
A fixed rate will stay the same during the life of the loan so your payment should also stay the same, while a variable rate can change over time and raise your costs unexpectedly.
Length of the Loan
Longer terms can mean lower monthly payments, but you'll pay more interest overall. If you plan to pay off the loan early, check for prepayment penalties – they can erase any savings.
Short-term loans might seem cheaper on interest but watch out for fees that can negate those savings.
Additional Fees
Fees are almost always part of the deal and understanding these upfront is important. It helps you plan your budget and avoid unexpected costs.
Different lenders and loan types come with their own specific fees, such as an application fee; origination fee; processing fee; late payment fee; and more.
What Lenders Consider
Not all lenders are the same, but most focus on similar things when reviewing your loan application. They're mainly looking for your ability to repay and your willingness to repay. If you understand these key factors, you can better prepare for the application process and boost your chances of getting approved.
History and Assets
Credit History – Your past payment behavior, how much credit you use, and how long you've had credit accounts.
Debt-to-Income (DTI) Ratio – How much of your income goes to existing debts. A lower ratio is better.
Assets – Your savings and investments, showing financial stability.
Collateral – (Secured Loans) The value of the asset you're using as security.
Payments
Income and Employment – Proof of stable earnings.
Purpose and the Economy – Why you need the loan and how the economy might affect repayment.
Loan Amount – Is the amount you're asking for reasonable based on your finances?
Down Payment – A larger down payment shows responsibility and reduces the lender's risk.
The Loan Process
Navigating the loan process can feel a bit daunting, but it's actually pretty straightforward! Each step is key to getting your loan approved and handled smoothly. While the unknowns might seem scary, the core steps for credit approval are quite similar, no matter what type of loan you're after.
Part 1: Your Application
First, you apply for a loan. You'll provide personal and financial details, including why you need the loan. The lender then reviews this information, especially your debt-to-income (DTI) ratio, to see if you can repay it.
Part 2: The Decision
Based on your creditworthiness, the lender will either approve or deny your application. If denied, they must tell you why. If approved, you both sign a contract outlining the loan terms, including interest and how long you have to repay the loan. The lender then pays out the funds.
Part 3: The Terms
Loan terms are agreed upon upfront. If collateral is required, it's noted in the documents. Most loans also detail the maximum interest and other agreements, like the repayment timeline.
A Note on Pre-Approvals
Loan pre-approval means a lender has conditionally determined you're eligible for a loan based on an initial financial review and a soft credit check. This gives you an estimated loan amount, interest rate, and terms, but it's not a guarantee of final loan approval. (You may hear the terms pre-approved and pre qualified. They’re similar, but different. Learn how.)
Getting pre-approved is an important step for auto loans and mortgages. Why? It gives you a better idea of what price range you can afford before you go shopping for that new ride or home.
Additional Resources
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