What Is a Loan?
A loan is a sum of money that a lender provides to a borrower, who in turn agrees to pay it back plus interest. The terms of a loan are agreed upon by both parties and outlined in a written agreement that details the principal, amount of time to repay the debt and any additional charges. Loans are often used to finance major purchases, cover emergency expenses or make home renovations. They can also help businesses expand and grow.
There are many different types of loans, each with its own set of terms. For example, personal loans may work a little differently than student loans or car loans, and lenders might use specific, purpose-driven names and offer varying rates based on the type of expense for which you’re borrowing the funds. Some lenders may also have more flexible credit score requirements for borrowers than others, and those with lower scores might choose to apply to a lender that makes it easier for them to qualify.
Depending on the type of loan, the principal amount, loan term and annual percentage rate (APR) may vary. The term of a loan is the amount of time it takes to pay off the entire debt, and it’s typically expressed in years. The interest rate is the annual cost of borrowing the amount of money you’re lending, and it can be calculated based on your annual payment amount and the principal and loan term of the debt.
Some loans are secured, meaning that the lender can seize or repossess an asset if you fail to make payments. Mortgages and auto loans are common examples of secured loans, and they typically require a down payment as well. Other loans, such as credit cards and many student and personal loans, are unsecured. These loans don’t require any collateral, but they generally have higher interest rates because the lender is taking on more risk.
Most borrowers agree to make monthly payments on their loans, with a portion of each payment going toward the interest and another toward the principal balance. The remaining balance is then amortized over the term of the loan, with the amount of each payment reducing over time.
Loans can be a great tool for funding big expenses or consolidating debt, but they can also add to your overall debt and hurt your credit scores if you don’t manage them responsibly. To improve your chances of qualifying for loans, it’s important to keep your debt-to-income ratio low and pay off any existing loans on time. To find a loan with competitive terms, consider shopping around for the best offers from reputable lenders. You can also find out if any lenders have prepayment penalties, which are fees charged for paying off your loan early. These are typically a percentage of the outstanding loan balance and can start at 2%.