In the world of finance, it's important to understand what loans are and how they can help you.

Let's face it, there may come a time when you're not able to pay cash for something, and a loan may be the next best option for you.

If that's the case, it's critical to understand what your loan agreement entails and the repayment terms, otherwise you might find yourself in a sticky situation.

At SovereignBoss, we're here to help you gain better control of your finances through expert and well-researched advice. Ready to get the inside scoop on what loans are?

Let's unpack this NOW!

What Are Loans?

Loans, a fundamental financial tool provided by lenders, range from personal loans to more specific types like home equity loans.

When comparing equity release and loans, it's important to understand the nuances. For instance, releasing equity through a mortgage can be beneficial for funding major purchases or covering expenses.

Moreover, mortgage equity release allows homeowners to access the equity in their home, providing a lump sum or additional income without the need for monthly repayments, unlike traditional interest-only mortgages.

Types of Loans

A loan might be secured¹ or unsecured², which means that you may be forced to put up a valued asset as collateral.

Loans can also be categorised as revolving or term.

This depends on whether money can be accessed on an as-needed basis or if the loan is granted in a lump sum and repaid over a specified period of time.

#1. Secured Loans

Secured loans are backed by a valuable asset, such as a home or car.

If the borrower defaults on the loan, the lender has the right to foreclose, repossess, or otherwise seize the collateral in order to reclaim the loan sum.

These loans are less risky for lenders, so they typically have lower interest rates³.

Secured loans include auto loans and home mortgages, but lenders may also offer personal loans secured by assets such as a savings account, certificate of deposit, or a car.

#2. Unsecured Loans

Unsecured loans, on the other hand, do not demand a collateral pledge from the borrower.

In this instance, the lender is unable to seize the underlying assets if the borrower defaults.

As a result, unsecured loan rates are generally higher and qualification standards are more severe.

Credit cards⁴, school loans, and most personal loans are instances of unsecured loans.

Requirements for Loan Qualification

Prospective borrowers must meet specific eligibility conditions, which vary per lender, in order to qualify for a loan.

The following are examples of common qualification requirements:

1. Debt-to-income ratio - The debt-to-income ratio (DTI)⁵ of a borrower is the difference between the monthly income and monthly debt repayments. Lenders generally prefer borrowers with a DTI of less than 36%⁶. However, this varies for each lender.
2. Credit score - Credit scores show a borrower's creditworthiness and tell a lender whether or not the applicant is high risk. Credit history, credit utilisation rate, and credit mix are all elements that go into a borrower's credit score. A fair FICO credit score⁷ of between 580–669⁸ is required to qualify for a loan; candidates with higher scores are more likely to qualify for competitive rates.
3. Income - Income, like DTI, shows a borrower's ability to repay a loan. While some lenders post minimal income requirements, others prefer to assess a borrower's ability to repay a loan on a case-by-case basis. Lenders' minimum income criteria differs, and many do not post them.
4. Work security - A borrower's stable employment indicates to a lender that he or she will have sufficient income to make repayments for the foreseeable future.

Interest & Fees

The interest rate on a loan is the fee that a lender charges a borrower in exchange for access to funds, or the cost of borrowing funds.

This can be in the form of simple or compound interest.

Simple interest is interest charged purely on the loan amount, but compound interest⁹ is charged on the loan and any past interest that has accrued.

The specific rate a lender will provide to a borrower is determined by their creditworthiness, the loan amount, and other factors that influence the lender's risk tolerance.

Common Questions

In Conclusion

If you're in need of immediate funds for something important, a loan can be an option.

Loans can be beneficial as long as they aren't used irresponsibly and all the financial terms are understood before signing on the dotted line.

It's crucial to consult a financial advisor for a better understanding of what loans are and what types of loans exist to help you decide which one is best suited for your situation.