Loans 101

Loans have become a very integral part of the modern world of finance. Loans can also be quite intimidating; if you have ever had an indebted college student as a friend, then they have probably told you (multiple times) about how scary their student loans are. However, when used wisely, they can be a valuable tool.

In this article we will talk about what a loan really is, how it works, and a few of the most common types of loans.

What is a Loan?

What would you do if you needed more money? Would you save up until you had the amount you needed? Maybe you would work extra hours or find a second job to earn more income.  For some, a better option may be taking out a loan.

To put it as simply as possible, a loan is purchasing more money.

How Does a Loan Work?

Purchasing more money sounds a bit strange at first.  Why would anyone sell you money? The answer is also pretty simple: to make money.

When an individual takes out a loan, they are expected to pay back the money they borrow over an amount of time that is agreed upon by both parties.  This amount of time could be anywhere from 5 months to 30 years.

The full amount of the loan is referred to as the principal. The principal of a loan is paid back in installments. An installment is a smaller amount of money that goes towards paying back the full amount.

Example

I go to my bank and ask to borrow $100. We both agree I will pay back the principal of $100 in ten equal payments over the course of ten months. With this agreement, I will end up paying an installment of $10 each month for the next ten months.

The above example would never happen in real life, as there is an additional component to loan agreements, called interest.

Interest

When someone provides a loan to someone else, they do so with the belief that they will make more money in the long term.  The way a lender makes money by providing a loan is called interest.

To put it simply, interest is the cost of the loan. Interest is expressed in the form of a percentage of the principal.

Example

Disclaimer: There are multiple kinds of interest, which will be explained in a different article. For the purposes of explaining the concept, we will only be using simple interest in our examples.

When I ask the bank for a loan of $100, they will only agree to lend me the money if I agree to pay a certain amount of interest along with paying back the principal.

Let’s say that the bank agrees to give me $100 if I pay back the principal with ten payments over the course of ten months with an interest rate of 6% per year.

After some calculation, this works out to me have to pay approximately $10.50 each month. $0.50 of this is an interest payment, and $10 of this goes towards the principal.

Once I have paid back my loan entirely, the bank will have their $100 back, plus they will have earned an extra $5 in interest payments.

If you are interested in seeing how this is calulated, you can check out the following link:

Simple Interest Calculator A = P(1 + rt)

Types of Loans

There are two main categories of loans: Secured and Unsecured. Let’s check out what these are.

Secured Loans

Secured loans are loans that are protected by an asset or collateral.  This means if the borrower does not pay back the loan, the lender has the right to take the asset or collateral that was agreed upon.

If the secured loan was used to purchase a house and the loan was not paid back, then the lender can take the house away from the borrower.

Because of the possibility of losing an asset, borrowers will usually take more care in making sure they are paid back.  Because of this, secured loans can allow borrowers to borrow higher amounts of money than unsecured loans.

Here are some common examples of secured loans:

• Mortgage
• Auto Loan (New and Used)
• Boat Loan
• Recreational Vehicle Loan

Unsecured Loans

Unsecured loans simply mean there is no collateral or asset associated with the loan. Student loans are a great example of these. If an individual does not pay back their student loans, the lender cannot take back that person’s education.

Because of the lack of collateral, lenders view these loans as riskier than secured loans. The higher level of risk means these loans usually have a higher interest rate than a secured loan.

Here are some common examples of unsecured loans:

• Credit Cards
• Personal (Signature) Loans
• Personal Lines of Credit
• Student Loans
• Some Home Improvement Loans

When to Take Out a Loan

Now that you know the basics of loans, you may be wondering when taking one out would be a good idea.

Loans can be used for many different scenarios, and ultimately it is up to the borrower as to whether they should take out a loan or pay for something out of pocket.

Here are a few ways people have used loans in the past:

• Consolidating or refinancing high-interest debt (we will write an article on this later)
• Making a large purchase (such as a laptop or household appliance)
• Taking a vacation
• Making a home improvement
• Paying for a medical procedure
• Paying for a wedding

Our advice to you is to use loans sparingly and only for necessary large purchases (home repairs or medical expenses) or purchases that will increase your net worth in the long term (college tuition or starting a business).

 

That concludes our introduction to loans! Did you learn something new? Have any other questions? Feel free to reach out to us or comment below!