What Are Loans: A Basic Guide

Understanding the Concept of Loans

Contributors: Nicola Date, Katherine Read. Reviewed by Francis Hui

Loans Are a Good Way to Get Money When You Need It. There Are Many Different Types of Loans That Can Help with Anything from Getting New Furniture to Paying off Credit Card Debt. Here Is Some Basic Information on What Loans Are, How They Work, and the Different Types of Them!

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What are Loans?

In the world of finance, loans are a form of borrowing that involves giving money to someone else who then has to repay it with interest. A loan is a type of debt because you will be paying back more than you borrowed.

But there’s no need to worry! Loans can be a great way for businesses and individual people alike to get what they need, even if they don’t have enough money in their bank account or assets on hand.

When you take out a loan, you’re borrowing cash from someone else to fund your goals and objectives. There’s an agreement in place that specifies the terms of when and how much you’ll pay back when the loan is due. The best part? You don’t need any collateral1!


Types of Loans

A loan might be secured or unsecured, which means that you may be forced to put up a valued asset as collateral. Loans can also be categorised as revolving or term, depending 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.

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. Because these loans are less risky for lenders, they usually have lower interest rates.

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 car.

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, loan rates are often higher and qualification standards are more severe. Credit cards, school loans, and most personal loans are instances of unsecured loans.


Requirements for Loan Qualification

Prospective borrowers must meet specific eligibility conditions, which vary by lender, in order to qualify for a loan. The following are examples of common qualification requirements:

  • Debt-to-income ratio – The debt-to-income ratio (DTI) of a borrower is the difference between the amount of money he earns each month and the amount of money he pays toward monthly debt payments. Lenders prefer borrowers with a debt-to-income ratio (DTI) of less than 36%. However, this criterion varies each lender.
  • Credit score – Credit scores show a borrower’s creditworthiness and tell a lender whether or not the applicant is a high risk. Credit history, credit utilisation rate, and credit mix are all elements that go into a borrower’s credit score. On average, a minimum FICO credit score of 610 to 640 is required to qualify for a loan; candidates with scores of 690 or higher are more likely to qualify for competitive rates.
  • 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 differ, and many do not post them.
  • Work security – A borrower’s stable employment indicates to a lender that he or she will have an adequate income in the 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.

Personal lenders normally provide rates ranging from 10% to 28%, but a decent personal loan interest rate is one that is less than the national average of roughly 12%. Mortgage lenders, on the other hand, usually charge rates ranging from 3% to 8%.

However, the specific rate a lender will provide to a borrower will be determined by her creditworthiness, the loan size, and other factors that influence the lender’s risk tolerance. When extending a loan, a lender may charge additional costs such as:

  • Application Fee – To cover the costs of processing the application, some lenders levy an application fee. Many lenders, however, provide fee-free loans, so keep that in mind while looking for a bank or online lender.
  • Origination Fees – help lenders cover the costs of processing applications, validating borrowers’ income, and even marketing their loan products and services. Personal loan origination fees typically range from 1% to 8% of the loan amount, however, fees vary depending on the borrower’s credit history and other criteria.
  • Late Payment Fee – When a borrower makes a late payment or a payment check is rejected due to insufficient funds, lenders frequently incur fees. These fines may not be imposed by lenders who offer fee-free loans.
  • Prepayment Penalty – Some lenders charge borrowers a price if they pay off their loans early. This is known as a prepayment penalty. Prepayment penalties are usually calculated as a percentage of the outstanding loan balance and start at roughly 2%. Many lenders, for example, seek to avoid prepayment penalties entirely in order to remain competitive.

In Conclusion

If you’re looking for a way to get out of debt, or just need some extra cash in general, then loans are 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.

Consult a financial advisor for a better understanding of what types of loans exist will help you decide which one is best suited for your situation.

Editorial Note: This content has been independently collected by the SovereignBoss advisor team and is offered on a non-advised basis. Sovereignboss may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations. Learn more about our editorial guidelines.

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Rachel Wait
Personal Finance Journalist

Rachel is an experienced finance journalist and editor with a particular interest in personal finance and consumer affairs. She has vast experience writing about money issues, property, insurance, and consumer affairs, and you’ll find her articles regularly featured in top media and newspaper publications.
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Written by
John Lawson
Founder SovereignBoss

John is passionate about education and has made it his life-long mission to assist UK citizens on their future financial options, with a specialist interest in equity release, and SovereignBoss is the natural extension of this passion.

Reviewed by
Francis Hui
Senior Risk Manager

Having held various high-level roles across the industry, Francis is truly an expert in aiding UK citizens in their financial decisions and risk analysis. His unique insight and statistical knowledge make him the perfect person to help you take your financial future to the next level.
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Katherine Read
Consumer Affairs Writer

Since joining the editorial team at SovereignBoss, Katherine has become focused on bringing transparency to finances and opportunities for those approaching retirement age. She writes on the topics of equity release, home reversion, and mortgages.

Nicola Date
Writer & Journalist

Nicola is a financial writer for SovereignBoss and is passionate about the opportunities that equity release can open up for homeowners. Her extensive business experience and deep understanding of the industry means that she’s always up-to-date with the latest developments.

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