How Do Loans Work? Common Loan Types, How Interest Works + Pre-Loan Checklist
Whether you’re taking out your first loan or it’s been a while since your last one, it’s always a good idea to review how loans work before you borrow. There are several types for various purposes, but many share common elements. So how do loans work? Here’s what you need to know to become a savvy borrower.
What Is a Loan?
In basic terms, a loan is money that you receive from a lender with an agreement to repay the money back later, typically with interest. The loan agreement spells out how and when you will repay the loan, the fees you’ll pay, and how much interest will be added to your debt.
5 Common Types of Loans
Consumer loans tend to fall within one of five categories. There may be different options to choose from within each category, but recognizing these basic types of loans can be an excellent first step in understanding how loans work.
1. Personal loans
A personal loan is a loan you can use for just about anything. Personal loans tend to be unsecured, which means the lender doesn’t require any collateral to issue the loan.
2. Auto loans
You can take out an auto loan to purchase a new or used vehicle, and then that vehicle acts as collateral for the loan. The lender will hold onto the vehicle’s title until you pay off the loan in full.
3. Mortgage loans
A mortgage is a loan that is secured by a home. You can take out a mortgage to purchase a home or take out a second mortgage to pay for other expenses using your home as collateral. There are many types of mortgages, including government-backed options, that can make it easier for people to become homeowners.
4. Student loans
Student loans help pay for higher education expenses like tuition, books, and housing. The government offers federal student loans, which don’t have a credit score or income requirement. Private student loans from banks and lenders are also available, but they generally don’t offer as many protections or benefits as federal student loans.
5. Refinance and debt consolidation loans
Refinancing means taking out a new loan to repay an existing loan. Refinancing can allow you to lower your monthly payments, consolidate multiple debts under one loan, and potentially save money if the new loan has a lower interest rate or better terms.
What Makes Up a Loan?
A loan is made up of several elements which are detailed on the loan agreement. These define how much money you’ll receive, how much your payments will be, and when the total sum of the loan must be repaid. Understanding these components will help you compare loan offers.
The principal is the initial amount you borrow when you first take out a loan. As you pay off the loan, the principal is the amount you still owe.
The loan’s interest rate is what the lender charges in exchange for lending money—typically a percentage of the principal. Lenders are often required to advertise an annual percentage rate (APR) in addition to the interest rate, which factors in the loan’s interest rate and financing fees to help you better understand the total cost of the loan.
Loan Repayment term
The repayment term is the amount of time you’ll have to repay the entire loan. A shorter loan term can result in paying less interest, but a longer loan term usually means lower payments.
Generally, installment loans require monthly payments, while some other loans may require weekly or biweekly payments.
Secured loans require collateral—something of value that the creditor can take or keep if you don’t repay the loan. For example, a vehicle is the collateral that secures an auto loan, and the lender can repossess the vehicle if you fail to make your payments.
Unsecured loans don’t require collateral, although creditors can pass the debt to a collections agency, which can negatively affect your credit score. In some cases, lenders can also sue for the money owed.
Origination fees are common for some types of loans, such as personal and student loans. The fee is often a percentage of the loan amount that is withheld from the loan proceeds when the loan is disbursed.
Lenders may require you to make a down payment to take out a secured auto or home loan. While the property is collateral for the loan, the lender also wants to be sure you have “skin in the game.”
Down payment requirements can depend on the lender, type of loan, and your creditworthiness. They typically range from 3.5% to 20% for some home loans and 10% to 20% for auto loans. However, you may also qualify for a loan without a down payment.
A prepayment penalty is a charge you may incur if you pay off a large part (or all) of a loan early. Prepayment penalties are not common on many types of loans, but you may encounter them on some mortgages and auto loans. The penalty may also only apply during the first several years of the loan.
Personal loan lenders may also charge prepayment penalties, although it’s not common. Alternatively, you may see lenders advertise that they don’t charge a prepayment penalty, but instead they offer loans with precomputed interest. LendingClub Bank doesn’t charge prepayment penalties or use precomputed interest.
Some loans may also have administrative fees or closing costs, which can add to the total cost of the loan. You may need to pay these fees to the lender or third parties, or you can sometimes add them to the principal balance. Many lenders also charge fees based on your actions, such as a late payment fee if you miss a payment.
How Do Loans Work with Interest (and the Different Types)?
When you take out a loan, your creditworthiness, how much you borrow, the type of loan, and your loan’s term can all impact the loan interest rate you’re offered. Additionally, loans may charge interest in different ways, which can impact the total cost of your loan.
Loans with a fixed interest rate will charge the same rate for the lifetime of the loan. As a result, your loan payments won’t change, and it can be easier to budget for the future. Most loan types are available with fixed rates, although you can sometimes choose between a fixed or variable rate.
Variable or adjustable
Variable or adjustable rates may increase or decrease based on changes in an underlying benchmark rate. Variable-rate loans often start with a lower interest rate than a comparable fixed-rate loan, but they come with the risk that the interest rate (and your payments) will rise over time.
Simple interest is an interest rate that only applies to the loan’s principal balance. With simple interest, part of each payment goes towards your principal and part goes towards interest. As the principal balance decreases, so does the amount of interest you pay every month. When your principal balance reaches zero, you’re done paying off the loan.
Compound interest can be more challenging to calculate because the rate applies to both the principal balance and the interest that has accrued on your loan. Interest may compound daily, weekly, monthly, or annually, and more frequent compounding leads to paying more interest overall.
Capitalization is the process of adding unpaid interest to your loan’s principal balance, which can result in more interest accruing—even if you have a fixed-rate loan. For instance, if you temporarily stop paying federal student loans by placing them in deferment or forbearance, the interest that accrues during that period may be capitalized once you start repaying the loan.
When a loan has precomputed interest, the amount of interest you need to repay is determined when you take out the loan. In those cases, making larger payments or paying off the loan early may be less favorable than it would be for a loan with simple interest.
Pre-Loan Checklist: Are You Ready for a Loan?
Loan requirements depend on the lender, type of loan, and how the loan works. However, there are a few basic steps you can take to get ready to apply for a personal loan.
1. Prepare your checklist.
Lenders may require copies of personal documents to verify your identity and income. These may include a government-issued ID, lease, utility bill, pay stubs, tax returns, and insurance documents.
2. Check your credit reports and scores.
Your credit history and credit scores can be important factors in determining whether you qualify for a loan and how much you’ll pay in interest. Good credit is typically defined as a score in the high 600s, but a score in the mid to high 700s can help you qualify for the best rates.
Before applying for a loan, check your credit score and review your . If you do find any abnormalities in your report, dispute them with one of the three credit bureaus immediately.
3. Review your income and debt payments.
Lenders will often compare your monthly income and debt payments to determine your debt-to-income(DTI) ratio. Keeping your DTI below 36% is a good rule of thumb when you’re borrowing money. A lower DTI could make it easier to qualify for a loan and manage your bills.
How Does a Loan Work at LendingClub?
Several types of loans are available through LendingClub Bank. While the loan amounts and requirements can vary from one loan type to the next, LendingClub makes it easy to quickly see your loan offers with a soft credit check, which won’t impact your credit scores.
What is the average interest rate for a car loan?
The average interest rate on an auto loan depends on whether you’re buying a new or used vehicle. According to the Experian Automotive Industry Insights report, in the fourth quarter of 2020, the average interest rate for new auto loans was 4.31%. The average rate for used auto loans was 8.43%.
Is prepaying your loan better in the long run?
Prepaying a loan may be a good idea because you’ll pay less interest overall—unless the lender charges a prepayment penalty or uses precomputed interest. Before you decide,
consider whether prepaying a loan will strain your finances or if you could make more money investing than paying it off.
How can I raise my credit score before I apply for a loan?
Consistently making your loan and credit card payments on time can help improve your credit score in the long run. If you have high credit card balances relative to the cards’ credit limits, paying down the balances and lowering your credit utilization rate may quickly improve your credit scores1.1
How does paying a loan work?
Your loan agreement will detail how paying back your loan will work. With many loans, you’ll start making payments soon after receiving the loan and continue making monthly payments until it is paid off. A portion of each payment may go toward the interest that has accrued since your last payment and your principal balance.
1Reducing debt and maintaining low credit balances may contribute to an improvement in your credit score, but results are not guaranteed. Individual results vary based on multiple factors, including but not limited to payment history and credit utilization.