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The Ultimate Guide to Understanding How a Loan Works

If you’ve never applied for a loan before, it can be a bit confusing and intimidating understanding all the different terms. Loan documents tend to be lengthy and they aren’t exactly beginner-friendly.

The good news is that a solid grasp of some key loan concepts can help you understand any type of loan much better. Here’s what you need to know about how loans work.

Types of Loans

The first thing to understand is that there’s a wide selection of loans available. The easiest way to separate types of loans to begin with is with the categories of secured or unsecured loans.

A secured loan is any loan where there is property of the borrower’s attached to the loan as collateral. The lender then becomes a lienholder on that property until the borrower pays off the loan. If you get a loan to pay for a piece of property, that property typically becomes the loan’s collateral. Examples include mortgages that have homes as collateral, auto loans that have cars as collateral and equipment loans that have the equipment as collateral.

You could also use a piece of property you already own as collateral. For example, with a title loan, you use a car that you own as the loan’s collateral.

Unsecured loans have nothing attached as collateral, and all the lender has is the borrower’s personal guarantee. If you default on an unsecured loan, the lender would need to either sue you or send the debt to a collection agency. A personal loan is a common type of unsecured loan.

Loan Terms

A loan term is the length of the loan. If a loan is setup to last for three years, then it has a three-year term. There are both short-term and long-term loans available. Short-term loans tend to be more dangerous because they typically have higher interest rates. Borrowers often end up in a cycle of debt with these loans where they can only pay off the interest each term, allowing them to refinance the loan but never pay down the loan principal, which is the amount originally borrowed.

Payment frequencies vary from loan to loan, but on long-term loans lasting one year or more, there are usually monthly payments. This is something you can arrange with the lender in some cases.

Installment and Balloon Payments

The two most common types of payment plans on loans are installment and balloon payments. With installment payments, you pay the same amount on every payment due date. This makes it easy to budget and know exactly how much your loan will cost you until you finish paying it off.

With balloon payments, you pay a much smaller amount every due date until the end of the loan’s term. At that point, you need to pay a much higher amount because you’ve paid off less of the loan. This makes it important to plan for that final payment.

Interest Rates and Annual Percentage Rates

People often get interest rates and annual percentage rates (APRs) confused, but they’re a bit different. The interest is what you pay to borrow the loan, but it doesn’t include fees the loan has. The APR combines the interest rate with any other loan fees for the total percentage of the loan principal that you’ll be paying per year.

For example, let’s say you borrow $1,000 and your loan has a one-year term. The annual interest rate is 6 percent and there’s a 2 percent origination fee when the lender issues the loan. The interest rate of 6 percent doesn’t accurately reflect the total amount you’ll pay for the loan in that year, because you’re paying $60 in interest and $20 for the origination fee. The APR would be 8 percent, equal to the $80 you pay that year for the loan.

When you’re getting a loan, it’s critical that you understand all the details, including the term, the APR and your monthly payments. Lenders often set up lower monthly payments with longer terms and higher interest rates. Even though you pay less per month this way, it costs you more overall. A little knowledge about loans goes a long way in negotiating the best deal for yourself.

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