The Basics of Borrowing Money
People borrow money for a variety of reasons, from purchasing a new home to starting a business, or furthering their education. These items range in necessity, and purpose, but have one typical commonality…. They are usually all too expensive to pay with cash in hand.
This is where lenders step in to provide the needed funds and allow borrowers to pay the loan back over a pre-determined period, with an agreed upon amount of interest. But, before taking out a new loan, it’s essential to understand the basics of borrowing money and ensure, as a borrower, you understand your loan options and basic lending terminology.
When you know the basics fundamentals of borrowing, you can ask the right questions to determine which loan will work best for your financial situation. Remember, this is just a basic outline of the lending process, for more specific information please contact one of our bankers.
Let’s review the basics.
Lending Products – What’s Available & What Are These Terms?
Loans are available in a wide variety of terms, ranging from basic promissory notes between family members to more structured secured loans like home mortgages and auto loans.
Below are some of the most common types of loan products:
- Personal Loans– A personal loan is typically a fixed amount borrowed over an agreed period and is repaid in installments, usually monthly.
- Credit Cards– A card used to buy items; you can also use it to transfer balances or withdraw cash, and you receive a statement of how much you have borrowed once per month. You then have the option to pay off the full balance on the credit card or any amount less than the full balance, if you make at least the minimum payment.
- Mortgages– Mortgages are loans distributed by banks to allow consumers to buy homes they can’t pay for all at once. A mortgage typically has a lien that is tied to your home, meaning you risk foreclosure if you fall behind on payments.
- Debt Consolidation Loans– A consolidation loan is meant to simplify your finances by combining several higher interest loans into a single consolidated loan. That loan is then used to pay off all or several of your previous debts and combines them all into one lower monthly payment.
- Auto Loans– They can help you afford a vehicle, but you typically must place a lien or your car and risk losing the car if you default on your loan.
- Payday or Cash Advance loans– are short-term loans that were originally intended to provide a borrower with money until their next payday but can now run for much longer periods.
Open-End & Closed-End Credit Options
The two basic categories of consumer credit are open-end credit and closed-end credit. Open-end credit, also known as revolving credit, can be used repeatedly for purchases up to your approval amount. The most common form of revolving credit are credit cards, but home equity loans, and home equity lines of credit (HELOC) also fall into the open-ended credit category.
Closed-end credit is used to finance a specific amount for a pre-determined period. Closed-end credit is also referred to as installment loans because consumers follow a regular monthly payment schedule that includes interest and charges until the principal is paid off.
Examples of closed-end credit include:
- Car loans
- Appliance loans
- Payday loans
The Interest Rate
You will typically pay interest on what you borrow and, in some cases, additional fees as well. Lenders usually refer to the interest rates as an annual percentage rate or APR (Learn more about APR on our “Explaining APR” blog). The interest rate is how much interest lenders charge on your loan balance and is a useful way of comparing the cost of borrowing on an annualized basis.
APRs work best when comparing similar types of credit over similar periods or “term.” The higher the APR, the more expensive the interest on the loan is. You should also confirm if your loan has a fixed interest rate or a variable rate that can change over time.
The interest rate is part of the lender’s fee for the use of their money during the loan period. The interest rate is typically a percentage of the total loan amount. There are two basic types of interest rates: fixed rates and variable or adjustable rates.
A fixed-rate is a set interest rate and does not change or adjust throughout the term of a loan. A fixed interest rate of 7% will stay at 7% for the life of the loan unless otherwise stated in the terms and conditions.
Variable interest rates can change over time and are usually based on the standard market rate or prime interest rate. For example, you may take out a loan with a variable rate at prime +3%. This means that you’ll pay three percent more than the current prime rate.
Secured and Unsecured Loans
All loans are either unsecured or secured with collateral. This refers to whether you are putting up interest in your personal assets, often referred to as collateral, to guarantee your loan.
If you have a secured loan, you have guaranteed your lender that they will be repaid one way or another by giving them a legal claim on something you own. If the loan goes unpaid or into default, the lender can take legal action on the collateral to recoup their investment. This guarantee gives lenders an extra degree of security and allows them to offer lower interest rates and better loan terms.
Unsecured loans do not require any form of collateral from the borrower during the approval process. With an unsecured loan, the lender has less legal protection if the loan does not get repaid or goes into default. For this reason, unsecured loans typically have higher interest rates than secured loans. Lending institutions can also require that an additional person co-sign or be legally obligated to repay the loan if the borrower fails to repay their debt.
The term of a loan is the length of time that the borrower has to completely pay back the loan. Most common personal loans have terms ranging from one to five years, while mortgages typically have 15-year or 30-year repayment periods. The term is commonly known as the maximum length of time the borrower has, to repay their loan.
Monthly Payment (Note not all Payments are Monthly)
Your monthly payment is usually calculated based on the length of your loan or “term” and your interest rate. However, there are several ways to calculate the required payment. For example, a credit card company may calculate your payment as a percentage of your outstanding balance. Make sure you know how much you need to pay each month and if that amount can change. You should confirm that the current and future payments fit within your budget.
Terms and Conditions
Loan terms can also be thought of as the terms and conditions of your loan, which your loan agreement spells out. When you borrow money, you and your lender agree to specific conditions or the “terms” of your loan. The lender provides a sum of money that you repay according to your loan agreement, which clarifies your rights and responsibilities under the loan agreement.
With some loans, you only pay interest-only payments or only pay off a small portion of your loan balance during the loan’s term. In those cases, you often need to make a onetime balloon payment or refinance the loan with another loan when the balloon payment matures and becomes due.
Qualifying for a Loan
Now you know more about borrowing in general, but what do you do once you decide you want to take out a loan? The first step is to find out if you can get approved for the loan you are applying for and to get approved for a loan; you will have to qualify. During the application process, most lenders will ask to see:
- Proof of income.
- Adequate savings.
- Acceptable credit history.
- Proof of any collateral securing the loan, if any.
- The lender may also calculate your debt-to-income ratio to make sure you can afford the new monthly debt payment.
After you provide information about your financial situation, the lender will evaluate your application and decide whether you qualify for the new loan.
In some cases, you may also have to secure the loan with collateral. This allows the lender to take legal action on your collateral if you’re unable to repay the loan. You may be asked to have someone co-sign the loan for you, which means they become equally obligated to repay the loan if you can’t.
Good debt – any borrowing that enables you to make money or improve your financial situation in the long term, such as buying a car so that you can travel to work or purchasing a home.
Bad debt – any borrowing that provides little or no return, such as borrowing to purchase unnecessary items, or items you can’t afford to purchase outright, or a debt in which you will struggle to repay, these are generally regarded as bad debt and should be avoided.
Most of us will need to borrow money at some point in our lives, whether it’s to purchase a home, lease a car, or pay off student loans and with a better understanding of the loan process, you can save money and make better decisions concerning your debt.
If you decide to borrow money, make sure you understand all the details of your loan agreement. Know what type of loan you are receiving and the details of your loan agreement, including whether the loan is tied to any of your assets or properties as collateral.
Also, familiarize yourself with your repayment terms. What your monthly payment obligation will be, how long you must completely repay the loan, and the consequences of missing a payment or defaulting on your loan. If any part of the agreement is unclear to you, don’t hesitate to ask for clarification. Talk with your lender or financial advisor about how to apply for a loan and how to find the right loan that works into your long-term financial goals.
If you have any questions or want to learn more don’t hesitate to reach out to our team at RoundBank today!