Understanding the intricacies of a loan is not always easy. Most people know what a loan is and have some general knowledge on the different terms, but may not fully understand the many different intricacies involved.

So over the next three weeks, we are going to go over some of the many aspects of loans. We will cover the general concepts, what to think about when taking out a loan, how to pay off your loan and much more.

To begin this series, we wanted to first cover some of the basics of a loan to give you a firm understanding of the concepts and language that are often used. And what better place to start then with probably the most basic question: What is a loan?

What is a Loan?

According to Investopedia, “A loan is the act of giving money, property or other material goods to another party in exchange for future repayment of the principal amount along with interest or other finance charges.”

To put it in even simpler terms, a loan is a sum of money that is borrowed and is expected to be paid back with interest.

Loans exist because many necessary things in life, such as a house, a car or education, cost significant money. Most people cannot afford the one time large payment to purchase these things, so they rely on other financial institutions, like banks, to loan them the money.

It is this lending of money and the agreement on how the person will pay the money back over a predetermined amount of time to the bank that make up the basics of a loan.

Key Concepts

Now that we have covered the basic definition of a loan, let’s start going over the basic concepts and terms you will hear when talking about loans.

Loan Balance

The loan balance is how much of the loan you have left to pay. Over time as you start to pay off your loan, this balance should drop. This can also be referred to as the loan principal.

Interest Rate

The interest rate is the amount the lender charges to give you a loan. In the most basic sense, it’s how the lender makes a profit off loaning money to borrowers. (There are other ways they make money, but we will get into that later).

The interest is usually a small percentage of the total amount of money loaned and often is worked into the regular payments you make.

Secured vs. Unsecured

There are two main types of loans: secured and unsecured loans.

A secured loan means you have pledged some asset, like a car or house, as a guarantee that you will pay off the loan. If you fail to pay the loan, the lender has the right to seize that asset as a way to recoup their losses. Because you are guaranteeing the lender will get something if you don’t pay, it gives them a lot more security and they can typically give you a lower interest rate.

An unsecured loan is the opposite of a secured loan in that they do not require any collateral from the borrower. As a result, unsecured loans are riskier for the lender because if you do not pay the loan, the lender has no backup asset to seize. Due to the riskiness, unsecured loans typically have a higher interest rate and may require you to fulfill other obligations, such as meeting a specific credit score or having a co-signer.

Loan Term

The loan term is the amount of time the borrower has to pay back the loan. It is important to note that the term is the maximum amount of time that you have to pay off the loan. You can always often pay off the loan before the term is complete, which is something EarnUp can help you do. But always check with your lender to see if this is an option.

Amortization

Amortization is paying off your loan with a fixed repayment schedule in regular installments over a period of time. More specifically, it is the relationship between your monthly payments and how much goes toward paying the interest and how much goes toward your loan principal. At the beginning of your loan term, most of your payment will go towards interest. As time goes on and you continuing making payments, a greater percentage of your payment will go towards your loan principal.

An amortization schedule will show you exactly how the relationship between your payments and your loan interest and principal will change over time.

Types of Loans

There are several types of loans, but for this article we are only going to cover the four main ones that most people will encounter:

Mortgage

A mortgage is a type of loan that you take out when purchasing real estate, such as a house. It is secured by the real estate you are purchasing, so if you fail to make your payments the lender can take back your property.

Auto Loan

An auto loan is a type of loan that you take out when purchasing a vehicle. Like a mortgage, it is secured by the vehicle you are purchasing. If you fail to make the payments, the lender can seize your vehicle.

Student Loan

A student loan is a type of loan designed to help people pay for higher education, such as bachelor’s degree, master’s degree or a doctorate. Student loans are unique because despite being unsecured, they can still have low interest rates and may have a repayment schedule that is delayed until you have completed your education. This is because many students are fairly young and are not part of the workforce, so this is a way to encourage them to obtain a higher education degree and ultimately get a job.

Personal Loan

Personal loans are another type of unsecured loans that can be used for almost any purpose, from consolidating debt to making large purchases such as home repairs. As an unsecured loan, personal loans typically have higher interest rates and may require you to meet certain standards before being approved (credit scores, ability to repay, etc.)

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Now that we’ve covered a few of these key concepts, you should have a better starting point when understanding your loans and what the different pieces can mean to you.

Parts 2 and 3 will go a little more in depth on interest rates, what to consider when taking out a loan and the many different ways to pay off your loan.

 

EarnUp blog content is for educational purposes only. Information shown is for illustrative purposes only and is not intended as financial advice. Please consult a financial adviser for advice specific to your financial situation. EarnUp makes no guarantees as to the accurateness, quality, or completeness of the information and EarnUp shall not be responsible or liable for any errors, omissions, inaccuracies in the information or for any user’s reliance on the information.