What Even is a Loan?
A loan is when you borrow money from a bank or lender to help pay for things that might be too expensive to buy all at once, like a car, house, or starting a business. Instead of paying the full amount upfront, you pay the money back over time in smaller monthly payments. To borrow, you pay a little extra called “interest,” which is the lender’s fee for the money. Loans make big expenses easier to afford by breaking them down into manageable payments spread out over months or even years.
Important Terms to Know
Here are some common loan terms to be familiar with:
- Principal: This is the amount of money you borrow from the lender.
- Interest: The extra money you pay to the lender as a fee for borrowing, usually a percentage of the loan.
- Credit Score: A score that shows lenders how trustworthy you are when it comes to repaying debt. Higher scores mean better interest rates and loan options.
- Collateral: Something valuable you own, like a car or home, that the lender can take if you don’t pay the amount back.
Types of Loans You Might Use
Personal Loans
Personal loans are like “all-purpose” loans that you can use for just about anything—whether it’s an unexpected car repair, setting up a new place, or a big life expense. Most personal loans don’t require you to put up any collateral (like a car or home), but they come with a set interest rate that you pay monthly. Personal loans are usually available at banks or online lenders.
Auto Loans
Need a car to get to work or school? An auto loan can help you buy a new or used vehicle. Here’s how it works: the car itself serves as collateral, so if you can’t make the payments, the lender can take the car back. Your credit score and the car’s age can affect the interest rate, which is the extra percentage you pay on top of the amount you borrowed.
Credit Cards
While credit cards aren’t technically a loan, they let you borrow up to a limit and pay it back over time with interest. They’re super convenient and can help you build a credit history, which is important for getting loans in the future. But be careful! Credit cards often have high interest rates, so try to pay off your balance each month to avoid extra costs.
Business Loans
If you’re interested in starting your own small business or side hustle, a business loan can help cover things like supplies, equipment, or marketing. Some lenders even offer small business loans specifically for young or first-time business owners. Just like with other loans, you’ll pay interest and have monthly payments.
Home Loans (Mortgages)
Even if you’re not ready to buy a home right now, it helps to understand how a mortgage works for the future. Mortgages let you buy a home by making monthly payments over a long time—usually 15 to 30 years. The home itself is collateral, meaning the bank can take it back if you don’t pay. Mortgages generally have lower interest rates than other loans because they’re secured by the property.
Loans for School: Understanding Federal Student Loans
College can be expensive, and many students need financial help to cover tuition, books, and other costs. Federal student loans are a common option because they often have lower interest rates and more flexible repayment options compared to private loans. Federal student loans are backed by the government and come with certain protections, like payment plans that can adjust based on your income after graduation.
Federal student loans generally come in two types: subsidized and unsubsidized loans. Both types help you pay for school, but they work differently when it comes to how interest is handled. Here’s what each type means and how they can affect the cost of your loan over time.
Subsidized vs. Unsubsidized Loans: What’s the Difference?
When it comes to borrowing for school, there are two main types of federal student loans you might hear about: subsidized and unsubsidized. Here’s what they mean and how they’re different.
Subsidized Loans
A subsidized loan is a type of federal student loan where the government helps you out by covering the interest while you’re in school. This means that while you’re taking classes, you don’t have to worry about the loan getting bigger due to interest. The government also pays the interest during a grace period (typically six months after you graduate) and during any deferment period (when payments are temporarily paused).
- Key Points:
- Interest doesn’t add up while you’re in school.
- Only undergraduate students with financial need can qualify.
- Overall, subsidized loans end up costing less because you’re not paying interest until you start repaying after graduation.
Unsubsidized Loans
With an unsubsidized loan, you’re responsible for all the interest from the moment the loan is taken out, even while you’re still in school. If you don’t pay the interest while you’re studying, it adds up and gets added to the total amount. That means you’ll end up paying interest on a larger amount over time, which can make the cost more expensive in the long run.
- Key Points:
- Interest starts building up immediately, even while in school.
- Available to both undergraduate and graduate students, with no financial need requirement.
- Unsubsidized loans can end up costing more over time due to interest buildup.
If you qualify for a subsidized loan, it’s generally the cheaper option because the government covers the interest while you’re in school. If you don’t qualify, unsubsidized loans are still a good option for funding your education but will cost more in interest over time.
How to Choose the Right Loan for You
When you’re deciding on a loan, here are a few questions to ask yourself:
- What do I need this money for? Knowing exactly why you need the loan will help you decide on the type that best fits.
- What’s the total cost? Look at the interest rate and monthly payments. Can you afford it comfortably with your income?
- How long will I be paying this back? Some loans are short-term (like a year or two), while others are long-term (like mortgages, which can last 30 years).
Tips for Responsible Borrowing
If you decide to take out a loan, here are some tips to keep your finances in good shape:
- Only borrow what you really need. It can be tempting to take more, but remember, every dollar borrowed means extra interest to pay back.
- Make your payments on time. Late payments can lead to fees and hurt your credit score.
- Read the fine print. Every loan comes with terms and conditions, so make sure you understand what you’re agreeing to.
What If You Don’t Pay Your Loan Back?
If you don’t pay your loans, it can lead to a few problems:
- Extra Fees: Missing payments can lead to extra fees, making the loan more expensive.
- More Interest: Unpaid interest keeps adding up, so the loan balance gets bigger over time.
- Credit Score Impact: Late payments can lower your credit score, making it harder to get other loans, credit cards, or even rent an apartment.
- Serious Default: After a while, if you don’t pay, the loan goes into default, which means you lose options like flexible payment plans.
- Collections: If a loan stays unpaid, lenders may send it to a collection agency, which could lead to more fees or a portion of your paycheck being taken.
To avoid these issues, try to keep up with payments, and if things get tough, talk to your lender—they may have options to help.
Final Thoughts
Taking out a loan can be a big decision, but with the right knowledge, you’ll be prepared to make smart choices. Loans are tools to help you reach your goals, whether it’s buying your first car, launching a business, or just covering an unexpected expense. Understanding how they work—and how to manage them—will set you up for financial success.
Helpful Links:
Loan Simulator | Federal Student Aid
How to Apply for a Personal Loan in 6 Steps | Intuit Credit Karma