7 Things to Know About How Loans Work

May 7th 2016

Principal and Interest

The amount given to a borrower is called principal. This person, business or agency must make payments back to the bank on a regular basis, and the lender receives a principal plus interest payment every time someone pays down a portion of the loan. The amount of interest included in the monthly payment varies and can be quite high.

Loan Term

The term of the loan indicates how long the person has to pay back the entire balance of the loan. Automobile loans vary between three to six years. Home loans go from 10 to 30 years. Student loans can range from 10 to 25 years or longer. The longer the term of the loan, the more interest paid over the lifetime of the loan. Shorter loan periods mean more is paid per month, but less interest accumulates.

Annual Percentage Rate

The annual percentage rate allows the actual cost of borrowing money for one year to be determined. If a loan is taken out for $1,000 with one year to pay it back at 7 percent APR, the lender is paid a total of $1,070. The total comes from the principal of $1,000 plus $70 interest, or 7 percent. Over 12 months, the monthly payment comes out to $89.17.

Interest Rates

Interest rates over the loan period may remain fixed or variable. A fixed-rate loan means the amount of interest paid never waivers over the loan period. A variable-rate loan changes interest percentages along a fixed schedule. For instance, a home mortgage may start at one rate for the first five years and then go up or down based on prime interest rate fluctuations until the principal is paid off.

Loan Agreement

Loan agreements spell out exactly when a borrower owes money, as well as grace periods and what happens when the borrower pays the loan off completely. Any legal disputes go back to the loan agreement signed by all parties when the loan originated from the financial institution.

Paying Extra Principal

Paying extra principal beyond the ordinary monthly payment means the loan is paid off faster. Designating extra money towards the principal does not lower the payment for the next month. Paying off the loan before the term ends means less interest is owed to the financial institution.

Default

When a loan is defaulted on, the borrower fails to pay the lender any amounts specified under the original terms of the loan. Defaulting on a loan may mean the rest of the principal must be paid in one lump sum or the collateral used for the loan must be handed over. For an automobile loan, the vehicle represents the collateral. For a mortgage, the home serves as collateral for the lender.

Conclusion

Loans occur when a lender gives a lump sum of money to a person, business or government agency in return for installment payments over time to slowly repay the amount borrowed. This creates a major economic engine for people who buy cars and houses, and for business owners who pay employees and buy more raw materials to make more products. Learn how loans work in today's consumer-based society.

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