A beginner’s guide to loans and fees
Loans and fees: A beginner's guide
- Loans are financial products that carry costs.
- Loans have four primary conditions: the principal, collateral, term and interest rate.
- Your credit score is a key factor in how much your loan costs.
- Compare lenders to get the best rates and conditions for your loan.
Loans are tremendously useful products that can help finance life goals such as purchasing a home or starting a business. There is reason to be cautious when pursuing a loan, however, as they are complex products with the potential to be extremely costly if used carelessly.
How loans are structured
It is important to remember that loans are financial products sold by lenders, such as a bank or credit union. As with any other product, lenders set the cost of a loan and make a profit accordingly. Whether a particular loan makes financial sense for the borrower depends on the individual situation, so it is essential to compare lenders before taking out any loan.
A loan has four primary conditions: the principal, collateral, term and interest rate.
The principal is how much money you are seeking from the lender. Basically, it is the loan amount prior to lenders adding their service charges.
Secured vs. unsecured
A secured loan is backed by a physical asset, such as a home or car, or a financial asset, such as a business’ invoices. This asset is called the collateral. When a borrower secures a loan with collateral, they are agreeing to give up the asset to the lender in the event that they default on the loan. This secured loan is less risky for the lender. An unsecured loan is not backed by any collateral and is far riskier for the lender, who will offset this increased risk by raising the cost of the loan.
Term vs. revolving
The term of a loan is how much time the borrower has to pay back the loan. Also known as an installment loan, a term loan sees a borrower receive a lump sum of money to repay over a fixed period of time. A revolving credit facility or line of credit, on the other hand, has no fixed term and can be drawn upon and paid off repeatedly. A credit card, for example, is a revolving credit facility. Term lengths will affect the cost of your loan. While a shorter-term loan may carry higher monthly payments, less interest is paid over the life of the loan. A longer-term loan may have lower monthly payments, but the extended term sees the borrower pay much more in interest over time.
Fixed vs. variable interest rate
The interest rate is effectively the cost of a loan. A lender will set an interest rate depending on how much risk they believe they are taking on. The higher the perceived risk to the lender, the more expensive the loan will be for the borrower. Interest is often reflected in an annual percentage rate (APR) that reflects the loan cost over the course of a year. The interest rate charged for a loan can be a fixed percentage over the term of the loan or a variable rate that changes, typically at a fixed percentage above the prime rate. The benefit of a fixed interest rate is consistency — you know exactly how much your monthly payments will be and can plan accordingly. A variable rate, on the other hand, will rise and fall with the prime rate. This can save you a lot of money when the prime rate is low, but potentially increase your costs heavily if the rate goes up.
How to reduce loan costs
The best way to save money on a loan is to get better loan conditions to begin with.
Improve your credit score
Your credit score is an assessment of your creditworthiness and has the most significant influence on what interest rate a lender will give you. Start working to build or improve your credit as soon as possible, as it takes time to demonstrate the consistent repayment behavior that will boost your credit score.
Consider a secured loan
Placing collateral against a loan will remove some risk from the lender, typically reducing your interest rate. Remember that this grants the lender rights to the asset in question should you default on the loan.
There are several types of lenders, including brick-and-mortar institutions, internet banks, online lenders and hard money (private) loan organizations. Many lenders specialize in particular fields, such as auto loans, student loans or home mortgages. Finding a trustworthy lender that provides a cost-effective loan takes some research and comparison. Shop around before you select a loan, as even a half-percent difference in interest rates can save you substantial costs.
On top of the loan principal and interest, most loans carry an application fee. More complex loans such as home mortgages or business loans often also have an origination fee or other charges. These fees are not always negotiable, but it is worth discussing with potential lenders, particularly if you are considering multiple options. Lenders may be willing to reduce or waive a fee to win your business.