What Are Loans?
• Loans come in many different forms, designed to suit a variety of needs.
• Taking out a loan can be a wise investment in your future, whether you need to finance a new home or a college degree.
• Borrowers must pay close attention to the terms and interest rates of any loan they’re considering and make sure they understand the risks.
Even the best savers may need to borrow money, and loans can be the stepladder that puts certain goals within reach. For example, a loan might allow you to invest in your growing business, take on a major home renovation, or buy the reliable set of wheels that’s going to get you to and from your dream job.
Loans come in a variety of types to fit all kinds of situations, whether you’re buying a house or refinancing credit card debt. But borrowing is a big financial step. To make sure a loan meets your needs, you’ll want to pay attention to interest rates and terms. You’ll also want to carefully weigh the risk you’d face if you have trouble repaying your debt.
How to Use a Loan
Loans can be used to finance a major one-time purchase, such as a wedding, home remodel, landscaping project, new appliances, or a car, boat or RV. They can also be used to start a business—providing the seed money that pays for office space, furniture and technology. You might also use a loan to fund an ongoing expense, such as school tuition or your child’s living expenses while she’s attending college.
Loans also offer a way to refinance outstanding debt. Credit card debt or student loan debt can be consolidated through a single loan that may offer a lower interest rate.
When to Borrow Money
When you’re considering applying for a loan, it’s important to take stock of how much you need. If you don’t have enough in savings to cover the amount you need, a loan may be a useful tool.
A loan might also make sense if the amount you need is too great to put on your credit card—either because the amount exceeds the credit limit on your card, or because you won’t be able to pay off the balance quickly. A credit card can be a convenient way to pay, but it’s likely to charge a higher interest rate than a loan. The interest on credit cards also compounds, so the longer it takes you to pay off the balance, the more your costs will increase.
Loans may also be helpful when you’re looking to consolidate credit card or student loan debt, since a loan typically lowers your interest rate and simplifies payments.
Types of Loans
When you sign a loan agreement, you agree to certain terms and take on some potential risks. That’s why you’ll want to study the loan terms you’re considering. Here are a few major differences between loans:
Secured vs. unsecured loans. Secured loans are backed by collateral—typically the item you’re purchasing with the loan, such as a car or boat. Unsecured loans, on the other hand, aren’t backed by collateral. Secured loans often have lower interest rates, but if you can’t make your payments, you may lose your collateral.
Fixed vs. variable interest rates. The interest rate on a fixed-rate loan won’t change in the future—it stays the same from start to finish. The interest rate on a variable-rate loan, however, may change in the future. Variable rates typically fluctuate based on a benchmark rate like the prime rate, which is the interest rate banks charge their best customers. A variable-rate loan may charge lower interest in the near term but could rise down the road and increase the payments you must make.
Short- vs. long-term. Shorter-term loans typically have lower interest rates than longer-term loans, but their monthly payments generally are higher.
Interest rates among lenders can vary significantly. And the rate you’re offered will also depend on your financial situation and credit rating. If you have a strong credit score, for example, you may be able to negotiate a better interest rate. You should also know how interest is calculated on the loan, such as whether it’s compounded or precalculated.
Loans are available in many different forms, designed to fit different scenarios. Some loans are intended to fund only particular purchases, while other loans offer more flexibility in how you can use them. Here are some common loan types:
• Personal loan. You can typically use this type of loan as you see fit, whether you’re building a deck or buying a boat.
• Auto loan. This type of loan helps you finance the purchase of a new or used car; the size of your down payment will affect the amount of your loan.
• Home loan. Also called a mortgage, a home loan helps you buy a house and is paid off over a long period of time, typically a term between 10 and 30 years.
• Student loan. In some cases, students themselves can qualify for student loans to help fund their college education. In other cases, parents are the borrowers. Or, students can borrow with a parent co-signer.
• Business loan. Whether you’re launching a startup or looking to expand, business loans can provide the necessary capital.
• Debt consolidation. Programs that consolidate your outstanding credit card balances or student debt into a single loan can offer a simpler way to pay as well as a lower interest rate.
Questions to Ask When Considering a Loan
As you evaluate whether a loan is the right tool to help you reach your goal, answer these questions to help guide your decision:
• Do you understand the term and interest rate? Consider whether the term gives you enough time to repay your loan, and use a loan calculator to run the numbers so you’re prepared for how much you’ll pay in interest over the life of the loan.
• Are you certain you’ll be able to make the monthly payments? Take a careful look at your budget and consider how your loan payments will factor in. Can you comfortably afford payments, or would they put a strain on your finances?
• What happens if you can’t pay, or you fall behind on payments? What fees or penalties would kick in? Could you face foreclosure on your home? Make sure the consequences for failing to pay are clear, so you understand what might happen if financial difficulty affects your ability to pay.
A loan is a contractual obligation. It’s important to fully understand the ins and outs of any loan you’re considering. That process can help identify the right choice for you.
This chart is titled "Remodeling a Home with a Personal Loan" Miguel needs $25,000 to renovate an old house with leaky pipes and tired flooring. He’s approved for a personal loan with a 6% interest rate and 36-month term, leaving him with monthly payments of $760.55. He makes payments each month during the three-year period, repaying the $25,000 he borrowed and paying $2,379.74 in interest over the life of the loan. Source: Loan Calculator, Bankrate.com, 2019.
Emily E. Smith is a freelance writer in Bozeman, Montana. She writes for national and regional publications on personal finance.
Good credit management is an important part of any loan decision. Learn more about how credit scores can affect future financial goals.
This article is part of Riverstones Vista Capital ’s Personal Finance Series: Level 101. View all topics in the series here.