Understanding the Four Basic Features of a Loan
Whether it’s for home improvement projects, paying off debt or financing an education, a loan can help you meet your short- and long-term financial goals. But it’s important to understand how loans work before making the significant, and sometimes risky, decision to borrow money.
While there are many types of loans, all have similar attributes that you should be familiar with before making the decision to apply for one. These include: principal, interest rate, monthly payment and term. By understanding these four primary features of loans, you can decide if they fit in with your budget and long-term financial plan.
A loan is a sum of money you borrow from a lender, which could be a bank, credit union, or online financial institution, or a person, like a family member or friend. You agree to pay back the money you borrowed plus interest at a later date, usually over time. The amount you borrow is called the principal, and you may also be charged additional fees, like an origination fee.
There are many different kinds of loans, ranging from personal loans to mortgages. However, they can be broken down into two broad categories: secured loans and unsecured loans. Secured loans are backed by an asset, such as a car or home, and have lower interest rates than unsecured ones. Unsecured loans aren’t tied to any assets, and they typically have higher interest rates.
The term of a loan is the length of time you have to repay it. A longer term means lower monthly repayments, but it also means you’ll pay more interest overall. A shorter term means higher monthly repayments, but it also means you’ll save on interest charges. Unless you have a specific reason for choosing a particular term, it’s generally best to choose the longest term you can comfortably afford.
Many lenders offer tools to help you estimate what your monthly payments will be and how much a loan might cost. These tools can be helpful in determining whether a loan is right for you, but it’s important to consider other factors as well, such as prepayment penalties. These are costs the lender may charge if you pay off your entire debt or a large portion of it before the end of the term. These can be expensive and should be avoided whenever possible.