Tips for Borrowing Money: What You Need to Know about Loans

Before you borrow money, it helps to understand the different moving parts of taking on debt. Loans help you afford life's larger purchases, like a car or a home, but if you haven't taken out a loan before, you might have some questions. What is a loan? How do loans work?

Don't worry. We'll help you get up to speed on everything you need to know about loans. The more information you have, the more informed financial decisions you can make.

What is a Loan?

A loan is simply one party lending money to another party with the expectation of repayment of the money borrowed plus interest. Borrowers then pay back the loan over a pre-defined loan term (how long the loan lasts) by making payments at regular intervals. Payment intervals are usually monthly.

Why are Loans Important?

Banks or financing companies often make loans to consumers to help make paying for large purchases more accessible. It's common for consumers to take out a loan to pay for cars, homes, or other major purchases like home renovations. However, loans can be used to pay for most anything where the purchase price is more cash than someone has on hand, and can be extremely helpful in getting out of credit card debt, as loan interest rates are typically much lower than credit card interest rates.

Loans are important to a consumer's credit profile, too. When you take out a loan and then pay off the loan responsibly, your credit score may improve over time. Other lenders will then be willing to lend you money and at more favorable rates than unproven borrowers since you've demonstrated that you're a good credit risk.

What do I Need to Know About Loans?

Loans have several moving parts. Before you take out your first (or next!) loan, it helps to know how they all work together.

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.

Loan Fees

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.

Loan Penalties

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.

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.

How Do I Get a Loan?

First, you'll need to find a lender. Asking friends for referrals and reading online reviews are good ways to find lenders that others have had positive experiences with. Once you find a lender, you can apply for a loan.

To borrow money through a loan, you'll always need to submit an application. On the application, you may be asked for a wide variety of financial and employment information to help the lender assess your ability to repay the loan. The lender will also check your credit history and credit score to determine how risky it might be to lend to you.

All of the information on your application will help a lender determine how much money they are comfortable lending you, at what interest rate, and for how long.

How Do Loans Work?

When you're approved, your monthly payments will start at a specific date. From that date forward, you'll be contractually obligated to make your payments on time until your loan is paid in full. However, be sure to read your loan contract thoroughly before signing. If you see anything you're not sure of, speak up and ask questions. By law, your lender must explain everything in your loan contract to you if asked.

How Do I Borrow Money Responsibly?

Responsible borrowing has two parts: knowing how much debt you can reasonably take on and being a reliable borrower.

Just because you can get approved for a loan doesn't mean you should borrow the money. Be sure to review your budget and make sure you have enough room to meet your existing financial obligations, maintain your emergency savings, and still make the payment for your new loan. Taking on too much new debt can put your savings at risk and cause you to increase your credit card debt should your savings run out.

After you take out a loan, being a reliable borrower means making your payments on time and communicating with your lender if the need arises. If you will be late on a payment, proactively reach out to your lender and let them know. Opening up a dialogue with your lender can maintain goodwill and help you protect your credit. A lender can't help you if they don't know you need help.

Now you know about loans – from key terms and why they're important for your credit to the process of getting one and making your payments. To learn more about the types of loans available and pros and cons to each, read Understanding Types of Loans and Line of Credit Options.