A loan is a sum of money that you borrow from a financial institution — a bank, credit union or online lender — or a person, like a family member. You then pay back that amount in full later, typically with interest.
All loans have similar attributes. But there are different types of loans, depending on how you use them.
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How do loans work?
Loans generally have four primary features: principal, interest, instalment payment and term. Understanding each of these will help you decide if a loan suits your needs, and whether you can afford to take one out.
Principal: This is the amount of money you borrow from a lender. For example, it could be $500,000 for a new house or $500 for a car repair.
Interest: The interest rate is the cost of a loan, which is how much you have to pay back in addition to the principal. Lenders determine your interest rate based on several factors, including your credit score, the type of loan and how much time you need to repay the loan.
Instalment payments: Loans are usually repaid to the lender at a regular cadence, typically monthly. Your monthly payment is commonly a fixed amount, so you know exactly how much money will come out of your account with each instalment.
Term: The loan term is how much time you have to repay the loan in full. Depending on the type of loan, the term can range from a few weeks to several years.
Types of loans
Loans fall into two broad categories: secured loans and unsecured loans.
Examples: A mortgage or a car loan.
For secured loans, the lender typically uses a physical asset, like your home or car, to secure its money if you cannot repay the loan as agreed. The lender bases your interest rate on the asset as well as your credit score and credit history. Secured loans typically have lower interest rates than unsecured loans.
Examples: A personal loan or a payday loan.
Lenders offering unsecured loans base your interest rate on financial factors like your credit score, income and existing debt. If you don’t pay back the loan as agreed, the lender can’t seize any of your assets, but it can go down the legal route and take you to court to get back the money. The lender can also report the default to the credit bureaus, which will hurt your credit score and your ability to get another loan in the future.
Unsecured loans typically come with higher interest rates and smaller loan amounts than secured loans.
The most common loan categories
Here’s a snapshot of different types of loans, many of which are used to finance specific purchases…
- Home loan. Also known as a mortgage, this is a loan used to buy a home. It’s a long-term debt, with terms typically lasting 25 or 30 years. Once you’ve paid off your mortgage, you own your home outright.
- Car loan. If you’re in the market for a new or used car, a car loan is a type of personal loan that can help you buy the vehicle you have your eye on. You’ll pay off the loan and interest over a fixed term, usually one to seven years.
- Personal loan. The money from a personal loan can be used for anything, though people tend to take out personal loans to cover large purchases like holidays or home renovations. You’ll agree on a repayment schedule, which is often between one and seven years.
- Payday loan. Sometimes called “small amount loan,” a payday loan lets you borrow up to $2,000, and you have 16 days to one year to pay it back.
- No interest loan. If you need cash for essential items, like a new fridge or an emergency car repair, you might be eligible for a $1,500 loan under the No Interest Loan Scheme (NILS). These loans are open to people with a Health Care Card, Pensioner Card or an after-tax income of less than $45,000 per year.
- Education loan. The government’s Higher Education Loan Help (HELP) initiative helps students and apprentices pay for expenses — like course fees and tools — while they’re studying or training. You’ll need to start paying back the loan when you’re in the workforce and earning more than $46,620 per year. You can put 1% to 10% of your income towards your repayments.
If you’re in the United States, read this article on the NerdWallet US site.