What Is a Loan?
A loan is a sum of money borrowed from a creditor that you pay back with interest. Loans can be secured or unsecured.
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Contributing Writer 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, and pay back in full at a later date, typically with interest.
All loans have similar attributes. There are different types of loans, depending on what you use them for.
» MORE: Compare the best personal loans
Loan terminology to know
Loans generally have four primary features: principal, interest, installment payments and term. Knowing these will help you understand how much you’ll pay and for how long, so you can decide if a loan fits in your budget.
Principal: This is the amount of money you borrow from a lender. It may be $500,000 for a new house or $500 for a car repair. The principal is the outstanding balance aside from interest or fees. As you repay your loan, more of your payment is applied toward principal, while less goes toward interest.
Interest: The interest is the cost of a loan — how much you have to pay back in addition to the principal. Many types of loans, like personal loans, federal student loans and auto loans, have fixed interest rates that stay the same for the entire loan. Variable-rate loans, which have fluctuating interest rates, are less common.
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 it.
The interest rate can differ from the annual percentage rate, or APR, which is the interest rate plus other costs like upfront fees. Because APR shows the full cost of borrowing, it’s typically the best way to compare loan offers.
Installment payments: Loans are usually repaid at a regular cadence, typically monthly, to the lender. Your monthly payment is commonly a fixed amount.
Loans work differently from lines of credit and credit cards, which are forms of revolving credit. Unlike loans, revolving credit lets you access money as you need it, pay it back and then borrow more. You only pay interest on the money you borrow, and you don’t repay before the billing cycle ends.
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 decades.
» MORE: Calculate loan payments
How do loans work?
You can apply for a loan at a bank, credit union or online lender. Once you’re approved and sign the loan contract, your lender will disburse funds in a lump sum.
Depending on the type of loan, the funds may go straight to you or a third party. For example, personal loan funds typically go directly to you as the borrower. But if you’re taking out an auto loan or mortgage, the borrowed funds often go to the seller.
You repay the principal amount you borrowed, plus interest and fees. Most loans are repaid in regular monthly installments over the loan’s term.
If you miss a payment, your lender could charge a late payment fee. Most reputable lenders report loan payments to the credit bureaus, meaning missed payments will hurt your score and on-time payments can help build it.
Types of loans
Here’s a snapshot of several different types of loans, as well as their terms and interest rates.
| Type of loan | Typical interest rate | Typical terms |
|---|---|---|
| Used to buy a home or borrow against home equity. | 5% to 7%. | 10 to 30 years. |
| Finances a vehicle purchase. | 5% to 28%. | 2 to 7 years. |
| Money you borrow from the federal government or a private lender to pay for higher education. | 4% to 15%. | 10 years. |
| A lump sum you borrow and use for almost any purpose, including debt consolidation or a major expense. | 6% to 36%. | 2 to 7 years. |
| A high-interest, small-dollar loan that doesn’t require a credit check and is due in full on your next payday. | 400%. | 2 to 4 weeks. |
Loans fall into two broad categories: secured and unsecured.
Secured loans
Examples: A mortgage or an auto loan.
With a secured loan, 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.
Unsecured loans
Examples: Student loans and most personal loans.
Lenders offering unsecured loans base your interest rate on your credit score, credit history, 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 report the default to the three major credit bureaus, which will hurt your credit score and possibly your ability to borrow in the future.
Unsecured loans typically have higher interest rates than secured loans. Most personal loans are unsecured loans; however, some lenders offer secured personal loans that you can back with an asset like a savings account or vehicle.
🤓 Nerdy Tip
Lenders that don’t check your credit or ability to repay a loan often charge high fees relative to the amount you borrow. For example, the average payday lender charges a $15 fee for every $100 you borrow, according to the Consumer Financial Protection Bureau, which equates to an APR of nearly 400%. Consumer advocates say loans with APRs above 36% tend to be unaffordable. How to get a loan
The process of getting a loan varies depending on the type of loan you’re seeking. Generally, a lender will review your credit score, income and existing debts to decide whether to approve your loan application. If the loan is secured, the lender will also evaluate the collateral.
For mortgages and car loans, you can typically get pre-approved before you start home or car shopping. This process may require a hard credit check and gives you a sense of how much you’ll be approved for what your interest rate will be.
For personal loans, you can often pre-qualify to preview your potential loan amount and rate. Pre-qualification doesn’t require a hard credit check, so you can compare offers from multiple personal loan lenders with no impact to your credit score.
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