Financing a loan for the first time can be overwhelming without understanding the best loan options for your situation. There are a variety of different loans available, and recognizing which loan type is best for you could potentially save you a significant amount of money in interest and fees.

A loan can involve an individual or multiple individuals applying to borrow a lump sum of money from a financial institution with the promise of repayment of the original loan amount, plus interest and/or other fees. The most important part of accepting a loan offer is understanding the terms. Let’s go over a few of the basics of understanding loans:
 
  • Principal: Original amount of money requested or borrowed
  • Interest: The amount of money a lender will charge you to borrow money
  • Annual Percentage Rate (APR): A measure of the interest rate plus additional fees charged with the loan
  • Term: Time frame in which the principal and interest will need to be paid back to the lender
  • Loan Payment: Stated amount that must be paid back weekly, bi-weekly or monthly by specific due dates to satisfy the agreed upon terms


In order to approve a request for a loan, lenders review your creditworthiness and assess how likely you are to pay back the loan amount. Your creditworthiness is based on a variety of factors, including your income, debt-to-income ratio, credit history (credit score) and whether or not you have any co-signers associated with your account. Being creditworthy is important because it can impact the interest rate and amount of your loan. Creditworthiness also plays a role in the type of loan you can be approved for. Before signing loan documents, it’s best to know what each term means, how it will affect your credit score and whether you can meet the repayment terms as stated in the proposal. Lenders will evaluate the risk of lending to the applicant(s) based on the following factors:  
 

Income: Does the applicant(s) have sufficient, steady income available to reasonably make the loan payment?
Debt-to-Income: Does the applicant(s) have the needed income to make a new loan payment after their current financial obligations (i.e. student debt, other loans, housing)? Financial institutions review the debt-to-income ratio to assess affordability for a new payment.
Credit History: Does the applicant(s) have history of repaying loans on time? Are there late payments, past due payments or collections accounts reflecting on their credit report?
Credit Score: Does the applicant qualify for favorable terms or a lower APR based on their credit score? What category does their credit score fall into from excellent to poor?
For more information on improving your credit or avoiding common credit pitfalls, check out our blogs 4 Steps to Rebuild Credit and Credit Mistakes You are making.

Once your creditworthiness is determined, the loan options available to you will be shared. There are many types of loans, but some of the most common include:

Secured Loans
A loan that is secured by an asset and used as collateral for the loan, such as a car or house, gives the financial institution security to recover borrowed funds if necessary.

Unsecured Loans
A loan that is not secured by collateral and is based solely on creditworthiness. Credit cards are an example of unsecured loans.

Revolving Loans
The most common first loan people apply for is a credit card, which is a type of revolving loan. Revolving loans allow a borrower to use a set credit limit, pay it down or off fully and reuse the credit as needed until they or the financial institution decide to close the account. When used wisely, credit cards can help build credit and improve odds for approval when applying for larger loans, such as auto, home or personal loans. 

Installment Loans
Installment loans, or term loans, differ from revolving loans. With an installment loan, the borrower will receive a lump sum of money up front and agree to pay it back with interest over a set period. The principal balance and interest are paid back within a specified period of time with fixed monthly payments, with the loan being closed at the end of the term when the final payment has been received. Additional fees or payments may be involved with installment loans, including a down payment, origination fees or penalty fees for early repayment. The most common types of installment loans include auto, home and personal loans.

Loans enable us to make large purchases we might not be able to afford otherwise, offering benefits like funding education, transportation and housing. With an understanding of the basics, we can make informed choices about loans and key factors to consider when applying.

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