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How Loans Work

Learn How Loans Work Before You Borrow

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When you borrow money, it’s important to know how loans work. With more information, you can save money and make better decisions about debt - including when to avoid it. Learn how loans work before you start borrowing.

The Cost of Money

What does it take to get money? More money. When you borrow, you have to pay back the amount you borrowed plus interest. You may also have to pay fees.

Costs are a key part of understanding how loans work and which one to choose; in general it’s best to minimize costs. However, they’re not always easy to understand. Lenders may not show exactly how loans work and what they cost, so it pays to run the numbers yourself.

For most loans, a basic Loan Amortization Calculator will illustrate how loans work. If you really want to play with the numbers, use a spreadsheet to see how loans work when you change the variables.

See: Excel Loan Calculators, or Calculate Loans From Scratch.

Costs can be tricky, so be sure to consider interest rates and transaction fees as you study how a loan works.

Paying Down the Loan Balance

It’s only a loan if you repay it. As you figure out how loans work, you’ll see that most loans get paid off gradually over time. Each monthly payment is split into parts: a portion of it repays the loan balance, and a portion of it is your interest cost. An amortization table shows how loans work this way, and how interest costs go down over time.

A loan may or may not have a "term" - a length of time over which you repay it. Some mortgages last for 30 years, while other loans may only last 3 years. Credit cards are "revolving" loans, meaning you can borrow and repay as many times as you want without applying for a new loan. The term affects how your loan works; shorter terms require larger payments.

Qualifying for a Loan

To get a loan you’ll have to qualify. Lenders only make loans when they think they’ll be repaid. Your credit is important in helping you qualify, since it shows how you’ve used loans in the past. Good credit means you’re more likely to get a loan at a reasonable rate. You may also need to show that you have enough income to repay the loan.

If you don’t have strong credit or if you’re borrowing a lot of money, you may also have to secure the loan with collateral. This allows the lender to take something and sell it if you’re unable to repay the loan. You might also have to have somebody with good credit co-sign the loan - they’ll promise to repay it if you can’t.

How Loans Work in Practice

Now you know more about borrowing in general, but how do loans work in everyday life? When you want to borrow, you visit with a lender and apply for a loan. Your bank or credit union is a good place to start; you can also work with specialized lenders like mortgage brokers and peer to peer lending services.

After you provide information about yourself, the lender will evaluate your application and decide whether or not to make the loan. If you’re approved, the lender will send funds to you (or it may go directly to another person - somebody you’re buying a house from, for example). Shortly after funding, you’ll start to repay - usually monthly.

If you want to save money, you can generally repay loans early. Figure out how your loan works to see if there’s any cost to prepay, and make sure it makes sense before doing so.

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