What is a Loan?

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Definition:

A loan is a sum of money that one party gives to another with the expectation that he or she will eventually pay the loan back, usually with interest.

🤔 Understanding loans

A loan is a sum of money that one party, usually a bank, lends to another party. The individual or entity pays the bank back the sum of the loan plus interest. There are many types of loans, including mortgages, student loans, and auto loans. In the case of a loan between a lending institution and an individual, the lending institution gives the individual a specific amount of money. The individual generally pays the amount back on a set schedule over several years. The individual will also have to pay interest, which is how the bank makes money from the loan. Most banks require a particular credit score to loan money to an individual, though it will likely vary from lender to lender. Popular types of loans include mortgages, student loans, auto loans, and personal loans.

Example

Suppose you were planning to buy a new car. The car that you want is too expensive to pay cash, but you’re confident that you’ll have the cash to pay it off over time. You head to your local credit union and ask if it will lend you the money for the car. They check your credit history and credit score and decide you’re a good candidate for a loan. They agree to lend you money to pay for your vehicle if you provide a small down payment. You’ll have to pay them back with interest over the term of the loan, say five years. While you owe the lender money on the car, the lender will hang onto the title. The vehicle serves as collateral, meaning you’ll probably lose the car if you stop making your loan payments.

Takeaway

A loan from your bank is like an IOU with legal consequences…

Signing a loan contract with your financial institution is like giving them an IOU. You’re promising to pay them back what you owe them. If you don’t, there could be some serious legal and financial consequences, such as the potential for a lawsuit or negative marks on your credit report.

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What is a loan?

A loan is an amount of money that one party gives to another with the promise that the borrower will pay the money back, usually with interest. Most often, the party offering the loan is a bank or lending institution. The borrower is often an individual, but could also be a business or other entity.

One type of loan that many people are familiar with is a mortgage. A mortgage is a loan that a lending institution gives to a borrower to cover the cost of the house. Then, the borrower pays the lender back, often over a long term, such as 15 to 30 years.

How does a loan work?

Though every loan will look different based on the parties involved and the type of loan, each loan will have a few key characteristics in common:

  • A borrower
  • A lender, which can be either an individual or a lending institution
  • The principal, which is the amount of money that one party borrows from the other
  • An interest rate, which is the price of borrowing the money
  • A loan term, which is the amount of time that the borrower has to pay back the loan

First, the lender gives the borrower a sum of money (aka the principal). The borrower then pays back the loan over a specific period (aka the term). In addition to paying back the principal, he or she also pays the lender interest, which is an extra percentage of the principal the borrower pays as the price of borrowing the money.

How do bank loans work?

Though it’s not necessarily always the case, most loans come from banks or other financial institutions. Bank loans tend to include a few extra steps in addition to borrowing the money and paying it back.

A bank will require a credit check before it will lend you money. The bank will look at your credit score, as well as your credit history, to see if you usually pay back your lenders. They’ll also require that you fill out an application. During the application process, you provide the information necessary for the bank to run its credit check. You’ll also provide other relevant information, such as your monthly income, so they can determine if you can afford the loan.

Another feature of a bank loan is a contract that lays out exactly how and when you’ll pay back the money you borrow. Depending on the type of loan, the payment schedule may last for anywhere from less than one year for a short-term loan to several decades in the case of a mortgage.

What credit score do you need to get a loan?

There’s no hard and fast rule for the minimum credit score you’ll need to get a loan. The requirements will vary from one lender to the next. However, you’ll have a harder time getting a loan with a bad credit score, which is anything under 650. Some lenders won’t give you money if you’re at or under that point, while others will offer loans with certain contingencies in place.

There are a few different ways you might be able to get a loan with a credit score at or below 650. First, check out your local credit union. Credit unions are often more lenient as far as the credit scores they’ll accept. Additionally, credit unions can’t lend money at an interest rate above 18%, which might be a better deal than you could get at a bank.

Next, consider getting a cosigner on your loan. If you have a bad credit score, a lender might be more willing to do business with you if you’ve got another person with better credit on your application. Both parties will be liable for the repayment of the loan.

You might also consider a less traditional route for obtaining a loan. Lending mechanisms such as online lending institutions, friends or family, and peer-to-peer lending (where you’re borrowing money from other people instead of an institution) might be an option.

What are the different types of loans?

Secured vs. unsecured loans

Every loan you get will fall into one of two categories: secured or unsecured. For a secured loan, the borrower puts up some sort of collateral. Collateral is an insurance policy for the lender. If you stop paying back your loan, then the lender can seize your collateral.

Some loans are inherently secured. For example, mortgages and auto loans are usually secured loans, and the lender can seize your home or your car if you stop paying them back. For other loans, you might have the option of offering collateral to ensure you get the loan. Secured loans often have lower interest rates, as the lender is taking on less risk.

An unsecured loan doesn’t require any collateral. These loans often have higher interest rates because the lender has less recourse if you stop making your payments. Unsecured loans include credit cards, student loans, and many personal loans.

Revolving vs. term loans

Every loan will also fall into the category of either a revolving loan (aka open-end credit) or a term loan (aka closed-end credit). A revolving loan is one that you can repeatedly borrow from as long as you continue to pay it back. A home equity line of credit is an example of a revolving loan.

Term loans are those where your lender agrees to give you a particular amount of money, and you’ll pay them back on a set schedule. You only get that money once — You can’t continue to use the loan for new purchases as you pay it off.

Types of loans

Mortgages: A mortgage is a sum of money you borrow from a financial institution to buy a home. Traditional loans have fixed interest rates and a life of 30 years. Other mortgage options allow for shorter terms or adjustable interest rates, meaning the rate on your mortgage varies with the market. Home loans are secured term loans.

Student loans: A student loan is a sum of money that someone borrows to pay for higher education costs. The federal government is the lender for most student loans, though private lenders offer them as well. Students usually don’t have to start paying back their student loans until they leave school. In the case of federal loans, students can often have monthly payments based on their income. Student loans are unsecured loans.

Auto loans: An auto loan is one a borrower would use to purchase a car. Auto loans are term loans that often last for between three and seven years. Auto loans are secured loans because your lender can repossess your vehicle if you stop paying.

Personal loans: Personal loans are term loans that don’t necessarily have a specific purpose. People often use personal loans to consolidate their debt or to fund big purchases like weddings. Personal loans are usually unsecured.

Home equity loans or lines of credit (HELOC): A HELOC is when someone borrows against the amount of their house that he or she already owns to help pay for expenses such as renovation projects or debt consolidation. Your home is the collateral for the loan.

How do you get a loan from a bank?

The steps to get a loan may look a bit different from one loan to the next. Usually getting a bank loan requires the following steps:

  1. Decide what kind of loan you need. This step is usually pretty easy to figure out. If you need money for a purpose that doesn’t have a specific loan to go with it, then you might need a personal loan.
  2. Decide how much you need to borrow. Take into account the total cost of your purchase, as well as the amount of any downpayment you might have.
  3. Fill out a bank application. This step gives the bank the information they need to run a credit check and decide if you’re a good loan candidate.
  4. Sign the paperwork. If your bank approves the loan, you’ll have a bit of paperwork to sign before you get the money.
  5. Pay the loan back. Your loan will probably come with a predetermined payment schedule and monthly payments that cover both the payments on your principal loan amount and interest.
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