How Do Loans Work?

A loan is a method to borrow money with the commitment that you will pay it back – plus interest – within a specific period of time. Before you take out a loan of any kind, it’s important to understand exactly how each component functions.


Loan Amount

Also called the principal, your loan amount is how much you initially borrow. Over time, you will have to pay back your principal plus interest.

Loan Term

The loan term is how long you will be paying back your principal, plus interest. This can also be referred to as ‘the life of the loan’. Depending on the type of loan, loan term might be anywhere from three years to thirty years.

Loan Interest Rates

The interest rate is the amount you will pay the lender for allowing you to borrow the money. It’s typically a percentage of the full loan amount. Banks will base their prime rate (lowest rate) on the federal funds rate. However, the interest rate you can qualify for depends on your credit history, income and type of employment.

** Annual Percentage Rate (APR) accounts for both interest rates and fees. If your loan has fees, then your interest rate and APR may differ. If there are no fees, then they will be the same.

Your Monthly Payments

The loan amount, loan term, and loan interest rate will determine your monthly payment.
Each month, you will pay a portion of your principal and any accrued interest for that month. With each payment, your remaining loan amount decreases, as does the amount of interest that accrues. This process of breaking up payments in this manner is called amortization.

*Note that not all loans are amortized, but the most common ones (like mortgages, auto loans, and personal loans) are.

Watch Out For Loan Fees

In some cases, you may need to pay loan fees. These could be any of the following:

  • Application fee- pays for processing the loan application

  • Processing fee - covers all costs associated with processing the loan

  • Origination fee - secures the loan (most common for mortgages)

  • Prepayment fee - a fee that’s applied for paying off the loan early (most common with auto loans and home loans)

Additionally, it is customary for lenders to have a late-fee policy if you miss a payment.

The lender will outline all of your loan details in a contract. Once you agree to the contract, you will be responsible for the loan.

Types of Loans

There are many types of loans to suit different purposes. Below are the most common types of loans.

Student Loans

Student loans are taken out to pay for education and education-related costs. They can cover tuition, books, housing, transportation etc. That said, they are not supposed to be used for anything outside of your educational needs.

Federal student loans tend to have lower interest rates than private student loans. These loans are the most flexible and offer deferred payments during a ‘grace period’ for 6 months after school. Federal student loans are also eligible for student loan forgiveness if you qualify.
Lastly, subsidized federal student loans have the interest paid for you while you’re in school.

Read our complete guide to Student Loans.

Personal Loans

Personal loans provide money for just about anything you may need. Some lenders, however, put restrictions on personal loans. The most common restriction is not being able to use them for education or college expenses. Personal loans can also be offered for a specific purpose like medical bills or debt consolidation.

Personal loans are extremely versatile, but watch out for high-interest rates or lenders requesting collateral in order to take out the personal loan.

Read our complete guide on How to Find the Best Personal Loan for You

Home Equity Loans

Home equity loans are also versatile, allowing you to use the money to purchase just about anything. The difference is that a home equity loan is secured by your home. This means if you don’t pay your loan, the lender could foreclose on your home.

According to the Federal Trade Commission, the amount you can take out in a home equity loan is limited to 85% of your home’s equity. However, the amount you can qualify for will also take your income, creditworthiness, and the market value of your home into account.

Read our complete guide on Home Equity Loans and HELOC

Auto Loans

Auto loans are offered by lenders to finance the purchase of a new or used car. These loans are generally secured installment loans, secured by the car itself. This means that if you do not pay your auto loan, the lender can repossess the car.
You can secure an auto loan through the car dealership themselves (an indirect market). Otherwise, you can secure your own auto loan by getting a pre-approval through a bank or credit union (the direct market).

Learn How to Find the Best Auto Loan Rates

Home Loans

Also known as mortgages, home loans are used to purchase a home. Similar to auto loans, the lender owns the home until the mortgage is paid off. If you do not make payments, then the financial institution can foreclose on your home.

Home loans are unique in that they have long terms, anywhere from 10 to 30 years. There are also specific types of home loans created for certain geographic areas (like the USDA home loan) and those created as benefits (such as the VA home loan).

Read our complete guide to Home Mortgage Loans and How to Find the Best Rates

Other Loan Types

Many other loan types exist, including credit builder loans and small business loans. There are also different ways to borrow money, like credit cards and lines of credit. You should review all of your options before jumping into any kind of debt.

Avoid predatory loans like payday loans or auto title loans, which charge outrageous interest rates. These target those with bad credit, putting the borrower in a precarious position. These types of loans should be avoided at all costs.

What You Should Ask Yourself Before Getting a Loan

Taking on debt is a big responsibility and you want to be sure you’re ready for it. Do a quick financial check and ask yourself the following questions before taking out a loan or line of credit.

“What Do I Need This Loan For?”

The purpose of the loan should be a top consideration factor. If you’re buying a home or consolidating debt, then it could be a worthy financial endeavor that would have long term benefits. However, if you are taking out a personal loan to go on vacation or buy new furniture, then you should reconsider.

Look at your finances and see if you can create a savings plan and open up a high-yield savings account. Saving and planning ahead will help prevent you from taking on unnecessary debt.

“How Much Will the Loan Cost Me?”

Your loan is made up of 3 main components:

  • Loan amount (principal)

  • Loan term (length of loan)

  • Interest rate and fees (what you’ll pay to borrow money)

These three components will determine how much the loan will cost you. Your payments will then be broken apart into monthly installments. Use a loan calculator to run the numbers for your specific loan.

“What Is My Credit Score?”

Before applying for any loan, you should know your credit score so you can check your eligibility. Depending on the type of loan, many lenders will have eligibility requirements for certain credit scores.

A good credit score (and credit history) typically means you’ll get the best rates from lenders. That’s because they see you as responsible with debt and less of a risk. You can improve your credit score in a variety of ways before applying for a loan. Since most loans are long term, it’s a solid idea to try and nab the best rate.

“Can Loans Affect My Credit Score?”

Yes, loans can affect your credit score in several ways. When you apply for a loan, you will receive a hard credit inquiry, meaning your score will drop by a few points. Beyond this, because your score is made up of average credit data points, how you manage your loan can also have a significant bearing on your credit score.

For example, FICO – the most common credit score model – breaks your credit score down into the following pieces:

  • Payment History (35%)

  • Amounts owed (30%)

  • Length of credit history (15%)

  • New credit/credit inquiries (10%) and,

  • Credit mix/ your types of credit(10%)

Clearly, having a good loan payment history will have the largest overall impact on your FICO credit score. This is one of the most important factors in growing (and maintaining) your credit.

“Can I Afford the Loan?”

The loan amount will depend on your creditworthiness and the limits set by each lender. The amount you choose to take out should always be exactly what you need and no more. Borrowing more than you need – or getting a loan with a high interest rate – can make it more costly over time. For example, a home loan payment may encompass more than your principal and interest rate. You would also need to account for home insurance, property taxes, and possibly private mortgage insurance.

What Is a Good Loan Rate?

Generally, a ‘good’ loan rate is lower than the national average. For example, the national average interest rate for a personal loan in 2019 Q2 was 9.41%. You would want to find a rate below this number. Do some research and find the national average for the specific type of loan you’re interested in, then shop around and compare your rates.

Keep in mind that the rate you are offered is highly dependent on your credit history and the lender. You should also note that you can negotiate your rate with lenders.

Which Loans Have the Lowest Interest Rates?

Home loans (mortgages) have the lowest interest rates out of all loan types according to Ensure that you know whether the mortgage rate is fixed or adjustable for the duration of the home loan.

Which Loans Have No Interest?

All loans have interest. That is the cost of borrowing money. That said, subsidized student loans offered to undergraduate students (who meet financial need requirements) do not accrue interest while the student is in school at least part-time. They also do not accrue interest during the grace period and periods of deferment. Only once you enter repayment do they begin accruing interest, making them the best type of student loan for undergraduates.

Can Loans Be Forgiven?

Yes, some student loans may qualify for loan forgiveness. The type of loan forgiveness your student loan is eligible for depends on the type of student loan and your current financial and career situation. Always review your options for student loan forgiveness prior to your repayment period.

Can Loans Be Transferred to Another Person?

In some cases, you can transfer your loan to another person. For example, a mortgage may be transferred to another person when that person can qualify for the loan and the mortgage contract is marked as assumable.

Car loans are a bit easier to transfer to another person. If the purchaser qualifies for the loan, the lender may transfer it. Alternatively, the person buying the car and transferring the loan may choose a new lender who will pay off the old loan and issue a new one with a shorter payment period.

Personal loans typically cannot be transferred to another person. However, if the personal loan has a cosigner and the loan defaults, the cosigner is responsible for the loan. Student loans are similar in that they cannot be transferred to another person, but when in default, a cosigner is responsible if they’re present on the loan.