6.8 The Basics of Loans
3 min read•june 18, 2024
Loans are a crucial part of personal finance, helping us achieve big goals like buying a home or starting a business. Understanding loan basics, from rates to monthly payments, empowers us to make smart borrowing decisions.
Loan calculations may seem daunting, but they're key to grasping the true cost of borrowing. By mastering formulas for monthly payments and interest charges, we can compare options and avoid surprises down the road.
Loan Fundamentals
Reasons for loans and terminology
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- Secure funds to purchase a home () or finance a vehicle ()
- Pay for higher education expenses such as tuition, books, and living costs (student loans)
- Obtain capital to start or expand a business (business loans)
- Cover unexpected expenses like medical bills or home repairs (personal loans)
- refers to the original amount borrowed from the lender
- Interest represents the cost of borrowing money, calculated as a percentage of the
- () expresses the yearly cost of a loan, including interest and fees
- defines the length of time given to repay the loan (30-year mortgage)
- consists of a portion of the principal and interest paid each month
- gradually reduces the loan balance through regular payments over the loan term
Loan Types and Factors Affecting Approval
- Fixed-rate loans maintain the same interest rate throughout the loan term, providing predictable payments
- Variable-rate loans have interest rates that can fluctuate based on market conditions, potentially changing monthly payments
- is an asset pledged as security for a loan, reducing the lender's risk
- is a numerical representation of a borrower's creditworthiness, influencing loan approval and interest rates
- compares a borrower's monthly debt payments to their income, helping lenders assess affordability
- A is someone who agrees to be responsible for the loan if the primary borrower cannot make payments
Loan Calculations
Calculation of loan payments
- Monthly payment formula:
- represents the monthly payment amount
- is the or loan principal
- denotes the monthly interest rate (annual rate divided by 12)
- signifies the total number of monthly payments (loan term in years multiplied by 12)
- Interest charge formula:
- represents the interest charge
- is the outstanding principal balance
- denotes the monthly interest rate
- Amortization tables break down each monthly payment into principal and interest components
- Over time, a larger portion of each payment goes towards the principal
- Simultaneously, a smaller portion of each payment is allocated to interest
Evaluation of total loan costs
- Total cost of financing a loan equals the sum of all monthly payments over the loan term
- Includes the principal amount borrowed and the total interest paid
- Additional costs to consider when evaluating a loan:
- Origination fees charged by the lender for processing the loan application
- such as appraisal fees, title insurance, and attorney fees
- Prepayment penalties imposed by some lenders for paying off the loan early
- Compare loan options by examining the APR, which includes interest and fees
- Carefully review loan terms and conditions to identify additional charges or penalties
- Calculate the total cost of financing for each loan option to determine affordability
Key Terms to Review (30)
Amortization: Amortization is the process of gradually paying off a debt over time through regular payments that cover both principal and interest. This approach allows borrowers to systematically reduce their loan balance while managing their financial commitments, making it a key concept in various financial transactions, including loans and mortgages.
Annual percentage rate: Annual percentage rate (APR) is the yearly interest rate charged on borrowed money or earned through an investment, expressed as a percentage. It provides a clearer understanding of the cost of borrowing or the yield on an investment over one year, helping consumers compare financial products more easily. The APR includes not just the interest cost but also any additional fees that may be charged, making it a comprehensive measure of the true cost of credit.
APR: APR, or Annual Percentage Rate, is a measure that expresses the total cost of borrowing on a loan or credit, including interest and any associated fees, as an annualized percentage. This figure helps consumers understand the true cost of loans and credit cards over a year, making it easier to compare different financial products. Knowing the APR can greatly impact decisions regarding loans, credit cards, and financing options when purchasing or leasing a vehicle.
Auto Loan: An auto loan is a type of financing used to purchase a vehicle, where the borrower receives a lump sum from a lender to buy the car and then repays that amount plus interest over a specified period. This loan is typically secured by the vehicle itself, meaning if the borrower fails to make payments, the lender has the right to repossess the car. Understanding auto loans involves knowing about interest rates, loan terms, and how they impact overall vehicle costs.
Business loan: A business loan is a type of financing provided to businesses to help them cover expenses, invest in growth, or manage cash flow. These loans can come from various sources such as banks, credit unions, or alternative lenders, and typically require repayment over a specified period with interest. Understanding business loans is essential for entrepreneurs to effectively manage their finances and make informed decisions about funding their operations.
Closing Costs: Closing costs are the fees and expenses incurred during the finalization of a real estate transaction, typically paid at the closing of a mortgage or property sale. These costs can include various fees such as loan origination fees, title insurance, appraisal fees, and attorney fees, which are essential for completing the transfer of ownership. Understanding closing costs is crucial for both buyers and sellers, as they can significantly impact the overall financial commitment involved in purchasing or selling property.
Collateral: Collateral is an asset that a borrower offers to a lender to secure a loan, ensuring that the lender can reclaim some value if the borrower fails to repay. This concept is crucial because it reduces the lender's risk and can influence the terms of the loan, such as interest rates and the amount borrowed. Essentially, collateral acts as a safety net for lenders, giving them confidence to lend more freely.
Cosigner: A cosigner is an individual who agrees to take responsibility for repaying a loan if the primary borrower fails to do so. This additional support can help borrowers with limited credit history or low income secure loans, as the lender sees the cosigner as a safety net. The presence of a cosigner often makes it easier to obtain favorable loan terms and interest rates.
Credit score: A credit score is a numerical representation of a person's creditworthiness, typically ranging from 300 to 850. It is calculated based on various factors, including payment history, amounts owed, length of credit history, types of credit used, and new credit inquiries. A higher score generally indicates better creditworthiness, which can influence the terms and availability of loans, credit cards, and other financial products.
Debt-to-income ratio: The debt-to-income ratio is a financial measure that compares an individual's total monthly debt payments to their gross monthly income. This ratio helps lenders assess a borrower's ability to manage monthly payments and repay debts, making it a crucial factor in budgeting, loan approval, and housing decisions.
Fixed-rate loan: A fixed-rate loan is a type of loan where the interest rate remains constant throughout the entire term of the loan, ensuring predictable monthly payments for borrowers. This consistency allows borrowers to plan their finances more effectively, as they won't be affected by fluctuations in interest rates over time. Fixed-rate loans are commonly used for mortgages and personal loans, making them a popular choice for those seeking stability in their repayment schedules.
Installment loan: An installment loan is a type of loan that is repaid over time with a set number of scheduled payments. These payments typically include both principal and interest components.
Interest: Interest is the cost of borrowing money or the earnings on invested funds, usually expressed as a percentage of the principal amount over a specific period of time. In the context of loans, interest is a key factor that determines the total amount borrowers will repay, influencing their financial decisions and long-term obligations. Understanding interest is crucial for evaluating loan options and making informed choices about borrowing and investing.
Loan agreement: A loan agreement is a formal contract between a lender and a borrower that outlines the terms and conditions under which money is borrowed. This document specifies crucial details such as the loan amount, interest rate, repayment schedule, and consequences of default, ensuring both parties are clear on their obligations. Understanding a loan agreement is vital for navigating financial responsibilities and ensuring compliance with legal standards.
Loan amortization: Loan amortization is the process of paying off a loan through scheduled, periodic payments that cover both principal and interest. Over time, the portion of each payment that goes towards interest decreases while the portion covering principal increases.
Loan term: A loan term refers to the duration of time over which a borrower is required to repay a loan. It is typically expressed in months or years and impacts the amount of the monthly payments, interest rates, and overall cost of the loan. A longer loan term generally results in lower monthly payments but may lead to higher overall interest paid, while a shorter loan term can mean higher monthly payments but less interest over time.
Loan-to-value ratio: The loan-to-value ratio (LTV) is a financial term that represents the ratio of a loan amount to the appraised value of the property being purchased. This ratio is a key indicator used by lenders to assess the risk of a mortgage loan, as a higher LTV suggests greater risk of default. It plays a crucial role in determining whether a borrower qualifies for a loan and affects the interest rates and terms that may be offered.
Monthly payment: A monthly payment is a fixed amount of money that is paid each month towards a loan or financial obligation. It is crucial in understanding how loans, interest rates, and repayment schedules work, as it determines the affordability and financial planning necessary for borrowers. Monthly payments can vary depending on the loan amount, interest rate, and term length, affecting overall costs and budgeting.
Mortgage: A mortgage is a type of loan specifically used to purchase real estate, where the property itself serves as collateral for the loan. This means that if the borrower fails to repay the mortgage, the lender can take possession of the property through a legal process called foreclosure. Mortgages are typically long-term loans with fixed or adjustable interest rates, and they often require a down payment from the buyer.
Origination Fee: An origination fee is a charge by a lender for processing a new loan application, essentially compensating them for the work involved in evaluating and approving the loan. This fee is typically expressed as a percentage of the total loan amount and can vary significantly depending on the lender and the type of loan. Understanding this fee is important as it can affect the overall cost of borrowing and impact the effective interest rate of a loan.
Personal loan: A personal loan is a type of unsecured loan that allows individuals to borrow money for various personal needs, such as consolidating debt, financing large purchases, or covering unexpected expenses. Since personal loans do not require collateral, they typically come with higher interest rates than secured loans. The borrower repays the loan over a specified term with fixed monthly payments.
Prepayment penalty: A prepayment penalty is a fee that lenders may charge borrowers if they pay off their loan early, either in full or through significant additional payments. This fee is designed to protect lenders from losing out on interest income that they would have earned if the borrower had continued making regular payments. Understanding prepayment penalties is crucial when considering loan options, as they can significantly affect the total cost of borrowing.
Present Value: Present value refers to the current worth of a sum of money that is to be received or paid in the future, discounted back to today's value at a specific interest rate. This concept is essential for understanding how money can grow over time, whether through simple interest, compound interest, savings methods, loans, or when considering the costs and benefits of renting versus owning a home. By calculating present value, individuals can make informed financial decisions based on the time value of money.
Principal: The principal is the original sum of money borrowed in a loan or invested, before interest or earnings. It is the base amount on which interest is calculated.
Principal: The principal refers to the initial amount of money that is either deposited or borrowed, which serves as the basis for calculating interest in various financial contexts. Understanding the principal is crucial, as it directly impacts how much interest will be earned or paid over time, influencing savings strategies and loan repayment plans.
Promissory Note: A promissory note is a written, unconditional promise to pay a specified amount of money to a designated party at a certain time or on demand. This financial instrument is key in loans, serving as a formal agreement that outlines the borrower’s commitment to repay the loan under specified terms. Promissory notes can vary in complexity, but they typically include details like the loan amount, interest rate, repayment schedule, and consequences of default.
Revolving credit: Revolving credit is a type of credit that allows the borrower to use or withdraw funds up to a pre-approved limit, repay it, and borrow again as needed. It is commonly associated with credit cards and lines of credit.
Student loan: A student loan is a type of financial aid specifically designed to help students pay for their education expenses, including tuition, fees, room and board, and other related costs. These loans can be offered by the government or private lenders and typically need to be repaid with interest after the student graduates or drops below a certain enrollment level. Understanding student loans is crucial for managing education financing and navigating the repayment process effectively.
Variable interest rate: A variable interest rate is an interest rate on a loan or security that fluctuates over time based on changes in a corresponding benchmark or index. These rates can adjust periodically, affecting the amount of interest owed by the borrower.
Variable-rate loan: A variable-rate loan, also known as an adjustable-rate loan, is a type of loan where the interest rate can change over time based on market conditions or a benchmark interest rate. This means that the monthly payments may increase or decrease throughout the life of the loan, which can affect the total cost of borrowing. These loans are typically tied to an index, such as the LIBOR or the prime rate, and are often attractive to borrowers due to lower initial rates compared to fixed-rate loans.