In an ideal world, we’d all have the funds necessary to make large purposes. In reality, this is not often the case. Fortunately, an entire industry exists to facilitate the lending of money between two parties. We will try to answer the question of how do loans work and provide a summary of each type of the most common loans. The concept of how a loan works is simple: one party wishes to make a purchase and borrows a certain about of capital from another party. The borrower agrees to pay back the loan over a set period of time, with interest. The borrower gets to make a large purchase and pay for it over time, and the lender makes a profit off of the capital they loaned out. Everyone wins.
There are many different loan types available, and in this guide, we’ll cover them and how you can obtain them in order to buy the things you need. We will explain the most common types of installment credit, otherwise known as a loan.
Loan Types
Student Loans
Paying for higher education can be an expensive proposition. Student loans exist to ease the burden and provide a way for prospective students to “cover the gap” between the funds they have available to pay for schooling and what their education will cost in total. There are two types of student loans which vary and knowing the difference will help answer the question of how do loans work.
Federal Student Loans
These loans are unique in that the funds come from private lenders but are guaranteed by the United States Government. Borrowers get more friendly repayment terms and rates with federal student loans, with the caveat that the government will ensure repayment occurs. Student loans, unlike other types of debt, cannot be discharged in bankruptcy, which means borrowers need to pay or could find themselves faced with wage garnishments or liens.
Federal student loans can be obtained by completing a FAFSA (Free Application for Federal Student Aid) application. You will need your financial information, along with tax information for yourself and, if necessary, your parents for the previous tax year.
Private Student Loans
For more expensive colleges and universities, federal student loans will not cover all of the costs. In these cases, many students opt to apply for private student loans, which come from private lenders (such as banks and credit unions) but are not guaranteed by the Federal Government.
Because the government does not stand behind these particular types of loans, getting approved for a private student loan is a bit more difficult. Borrowers initiate the process by reaching out to their lender of choice for an application but will either need a sufficient credit history of their own or a co-signer with acceptable credit to get their private loan application approved.
Private Student Loan Lenders
Personal Loans
In some cases, someone may wish to borrow money, not for a specific purchase, but instead, have access to a credit line that could possibly have a lower interest rate than a credit card. Personal loans fulfill that need and provide borrowers a way to obtain capital without having a specific need in mind (such as education or a car purchase). There are two types of personal loans.
Secured Personal Loans
Think of the word “secure” in this way — the bank lending money has a way to “secure” some of or all of the funds should a borrower not pay them back. With a secured loan, a form of collateral is put up to provide the lender with a way to recoup its money should a borrower default. This collateral often takes the shape of a borrower’s home or car. Because the borrower has some skin in the game, secured personal loans are oftentimes easier to obtain than unsecured personal loans.
Unsecured Personal Loans
An unsecured loan is a more risky investment for a lender. The borrower does not put up any collateral when borrowing money, thus the lender has no guarantee they will be able to collect should a borrower fall into default. As a result, unsecured personal loans are more difficult to obtain, as borrowers will need to display a credit history that is acceptable and will likely need to have a job in order to borrow.
Both of these loan types can be obtained through private lenders, such as banks. Before applying, it’s a good idea to obtain a credit report and credit score, as these will help determine the interest rate on the loan.
Auto Loans
Automobiles are a necessity for some people in their day-to-day lives. Auto loans exist to address the reality that someone may need to purchase a new vehicle but may not have all the funds necessary to do so.
Presently, there are two different types of auto loans available, both very similar but each with a slightly different approach toward financing. Blank check financing essentially provides a car buyer with a credit line up to a certain amount of money. The borrower can use the “check” to find the car they want and purchase it, which then starts an auto loan with the lending bank. The other type of auto loan is a more traditional loan, where the borrower offers a down payment (usually 20%) in order to obtain the loan. These more traditional loans usually have a lower interest rate as a result of the borrower offering funds upfront.
Auto loans can be obtained in one of two ways: directly through a lender, such as a bank or credit union, or through an auto dealership, which facilitates the loan through its own network of lending institutions. As with any loan, a borrower should check their credit prior to applying for a loan in order to see where they stand and get a general idea of the interest rate they’ll pay.
Mortgages
Though not often called a loan on its face, a mortgage is one of the largest loans a person can have during the course of their life. A mortgage is used to help a borrower purchase a home without having all of the funds upfront, but unlike other loans (such as personal loans or auto loans), the repayment period for a mortgage can span decades.
There are two types of mortgages available to potential homebuyers, depending on their buying situation.
Federal Housing Administration Loan
For borrowers who have never before owned a home, a government program exists to facilitate lending that is not unlike the federal student loan program. It’s called the Federal Housing Administration Loan program, and it offers potential homebuyers a way to secure the funds for a home purchase with a low down payment, low closing costs, and more lenient credit requirements. An FHA loan can be applied for on the U.S. government’s Department of Housing and Urban Development website.
Traditional Mortgage
For those who are not buying their first home, traditional mortgage options exist. These serve borrowers who are able to front a more hefty down payment (usually 30%), acceptable credit, and a consistent work history. Those who choose to obtain a traditional mortgage should pull their credit reports in order to get a general sense of where they stand, as their credit rating will ultimately factor into how much they’re approved for and the interest rate they’ll pay.
With all mortgages, the lender “owns” the home until the borrower has paid off the full amount of their loan. Should a borrower default on their mortgage payments, the lender could foreclose on the property, issue an eviction to kick the borrower out and sell the home in order to recoup the mortgage debt.
How Do Loans Work
A lending institution provides you with money to purchase or pay for something, and in return, you promise to pay it back with interest over a certain period of time. The two main types of loans are installment credit, which is what everyone most commonly understands as a loan, and revolving credit.
