Loan Basics

When individuals take out loans, they borrow an amount of money from a lender with the requirement that they repay at a defined future point. A loan is thus a form of debt. In the United States, a lender may be a financial institution, a government body, an organization, or another entity. Each category of lender offers different types of loans with greatly differing terms. Most lenders require borrowers to pay interest, an additional fee typically based on a percentage of the amount borrowed, when making payments on a loan. Although numerous types of loans exist, some of the most common varieties include personal loans, mortgage loans, and student loans. Borrowers’ creditworthiness plays a significant role in their ability to obtain a loan and potentially a low interest rate, and at times, unscrupulous lenders prey on individuals who are unable to obtain loans elsewhere. As such, the lending and borrowing of funds is heavily regulated.

Background

The practice of borrowing and lending money has been a common one for millennia, although procedures have evolved significantly over time and in different cultures. Moneylending was at times a controversial topic, often because of its association with the charging of interest. One particular type of interest, known as compound interest, was particularly controversial and was banned in some ancient societies, including the Roman Empire. Over the centuries, a variety of lending practices became standard, and by the twentieth century, loans were a fixture in the both finance industry and society of the United States.

In the United States of the twenty-first century, numerous types of loans are available to individuals, small and large businesses, and institutions. Perhaps the best-known loans are those targeted toward individuals, which include mortgage loans, vehicle loans, and student loans. A mortgage loan enables individuals, a family, or a small group to purchase real estate when the buyer is not able to pay entirely in cash. Such loans, which often cover 80 percent or more of the total price of the home or land, are typically offered in fifteen- and thirty-year terms, although some shorter-term mortgages are available. Mortgage loans are typically offered by banks and credit unions as well as by specialized mortgage lenders. Vehicle loans, as their name suggests, are loans taken out for the purpose of purchasing vehicles such as automobiles. They are typically offered by standard financial institutions as well as by lenders associated with vehicle dealerships. Student loans are specifically intended to fund one’s education, usually at an institution of higher learning, and can be used to pay for one’s tuition and fees, textbooks and school supplies, and room and board. The federal government offers numerous such loans, and student loans may be obtained from specialized private lenders as well.

The broadest category of loans available to American borrowers are known collectively as "personal loans." Unlike more specialized types of loans, which are geared toward specific financial transactions, personal loans can be obtained in a wide variety of situations. Money borrowed through a personal loan may be used to pay bills, purchase consumer goods, fund vacations, or pay for nearly any other expense. Because of their flexibility, personal loans present a risk to some borrowers, who may be tempted to make unwise purchases with borrowed money without considering the financial ramifications of taking out a loan.

Overview

Although individuals may choose to obtain a loan for one of numerous purposes, the general process of obtaining and paying back a loan is typically very similar regardless of the specific loan product in question. Prior to borrowing money from the vast majority of lenders, individuals must complete an application process that takes a number of personal financial factors into account, including the applicant’s creditworthiness. When the applicant is approved for a loan, he or she must then determine whether the loan’s terms, which include its interest rate and payment schedule, meet his or her needs. As taking on debt can have a significant effect on one’s credit, overall financial situation, and ultimately life as a whole, lending is heavily regulated by the US government. Prospective borrowers must also be sure to research their loan options carefully and to avoid borrowing money from lenders who offer loans at unreasonable terms.

When seeking a loan, one must first determine what kind of loan provider offers loan products that meet one’s needs. Mortgage and vehicle loans are offered by banks and credit unions as well as by lenders specializing in those particular products. Many individuals seeking student loans prefer to obtain them from the federal government, as such loans are often subsidized so that no interest accrues until the student has graduated and also often allow for income-based repayment plans. However, one may choose to take out private student loans, which have varying terms, when additional funds are needed. As the broadest category, personal loans are available from most financial institutions, and one may choose to obtain a loan from an institution with which one already has a relationship or from a different institution. In all cases, prospective borrowers must compare the advertised interest rates, payment plans, and fees associated with each lender’s offerings and determine which is best. Although the borrower may not qualify for the specific terms advertised, depending on factors such as his or her credit score, the comparison process is an important step and provides a general idea of the terms available.

After finding one or more appropriate providers, borrowers must complete a paper or electronic application for a loan. Loan applications typically ask for basic information such as name and address as well as the borrowers’ Social Security numbers, income, and employment information. Such information allows lenders to assess prospective borrowers’ creditworthiness and ability to pay.

Creditworthiness, or perceived ability to repay the money borrowed, is a crucial factor in obtaining a loan. Lenders have numerous ways of assessing creditworthiness, but one of the key tools is a credit score. A credit score is a number that indicates individuals’ creditworthiness based on a number of factors. Some of the factors taken into account include the number and age of the individuals’ open lines of credit, the number of late payments individuals have made, and whether they have defaulted on a loan within the past several years. Lenders also typically take income and total debt-to-income ratio into account when determining people’s ability to pay. Individuals with good credit are generally considered safer borrowers and may be offered loans at lower interest rates than those with poor or middling credit. Those with bad or no credit may sometimes be able to obtain loans with the aid of cosigners, people who jointly apply for loans and guarantee that payments will be made, or by providing collateral, often a piece of physical property that may be repossessed by lenders if individuals fail to pay.

Although individuals often have the ability to repay loans at any time, in many cases, they will make partial payments in accordance with a payment schedule mandated by the lender. For example, a loan with a three-year term may require the borrower to make a set payment every month for thirty-six months. A loan payment typically consists of a principal payment, based on the original amount of money borrowed, and an additional interest payment. Lenders offer a wide range of interest rates, typically based on factors such as the length of the loan term and the borrowers’ creditworthiness. As high interest rates typically require individuals to pay lenders far more money than they originally borrowed, prospective borrowers must carefully consider whether a high-interest loan is truly the best option. Borrowers must likewise be aware of whether lenders charge simple interest or compound interest. The former is based on a percentage of the principal. On the other hand, compound interest is periodically added to the loan principal as it accrues, and further interest then accrues based on the new total amount. A loan charging compound interest can dramatically increase the borrowers’ debt if borrowers are not vigilant.

Another factor that affects interest rates is whether a loan is secured or unsecured. The former designation refers to loans in which a piece of property or other possession is used as collateral, while the latter refers to loans with no collateral. Some loans are inherently secured by the property they were used to purchase, such as a home or a vehicle; for example, if borrowers cease to make mortgage payments, the mortgage lender can seize the home or other property through a process known as foreclosure. Nonspecialized personal loans may also be secured by a piece of property or the funds in the borrower’s bank account. Student loans are typically unsecured and thus not based on physical or other collateral, but lenders may choose to garnish the wages (that is, take a portion of one’s paycheck as a payment) of individuals who have defaulted on their loans. Secured loans typically have lower interest rates than unsecured loans, as they provide the lender with a relatively easy method of recouping some of their money should the borrowers cease to pay.

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