Loans are agreements you make with the bank to borrow a certain amount of money which you will pay back over time (called the Loan Period). Loans can be used for almost any monetary venture, but they primarily fall into 3 main categories: Home Loans (Mortgages), Car Loans, and Personal Loans.
Since the borrower is using a service of the bank’s to purchase something they would otherwise be unable to, the borrower agrees to pay Interest on the loan, as well as the amount they borrowed back. Interest is basically the fee for not being able to return all the money at once. This is how most banks make money.
In addition, the bank also needs some sort of assurance that the borrower will be able to pay back what they borrowed. The borrower agrees to put down an item of equal value, called collateral, which the bank can take if the borrower is unable to pay back the loan (which is called defaulting on the loan). In most cases, it is the item you are purchasing that is put down as collateral, so if you’re getting a mortgage, you also agree that the house belongs to the bank if you cannot pay off your mortgage. Borrowers can also choose to not put down any collateral on Personal loans, taking out an “Unsecured” loan, but the interest rate is much higher.
Finally, there is the Loan Period, or the amount of time you agree to pay off your loan in. The loan period tends to be fairly long for large purchases, such as a house, and shorter for smaller purchases, such as a car or motorcycle. The agreement between you and the bank is that within that time frame, unless the loan agreement is changed or taken over by another company, the loan will be entirely paid off.
- Car Loans
- Personal Loans
- Student Loans
Example Home Loan
For standardized loans that are commonly taken out, such as a car loan or a mortgage, the market usually takes the item purchased as collateral. That means, if you default on a car loan, the bank gets the car (and any payments you’ve managed to make so far). That’s part of the loan agreement.
For personal loans, which can be used for pretty much anything else the common consumer might want, the borrower must choose an item to put down for collateral. You can use any item in your possession, so long as it has enough value to equal the amount of the loan. This means you can use your car, your house, or even your jewelry as collateral.
|Can I use my car as collateral for a personal loan if I already have a car loan? What about my house?
The short answer is maybe.
Equity is the amount of value of an item minus the amount still owed on that item. To determine the amount of equity on an item, find out the current value of you’re the item, such as by checking Kelly Blue Book or having your house appraised; then, subtract the amount you have left on your current loan(s) on the item. That amount is the equity. Equity can change through a number of factors:
- Making payments on the original loan.
- The market for the item improving (such as the value of a house rising because of the housing market)
- The item itself improving (such as repairs, remodeling, or additions)
- Refinancing (cash out refinancing is refinancing a house and borrowing more than you owe to pay the previous lender, and taking the difference as your own)
|Equity can be negative. For example, you may have bought a house in 2006 for $200,000, but the housing market crash dropped your house’s value to $125,000. The equity would be -$75,000. You can’t borrow against negative equity, but that still doesn’t nullify your original loan agreement, and you will either need to refinance or pay off the original $200,000.|
Interest Rates (also called Annual Percentage Rates, or APR) are the percentage you pay on top of your loan for being able to borrow the money. The amount for the interest on a loan varies according to the Interest Rate that you agreed upon when you signed for the loan. There are two different types of Interest Rates.
Fixed Interest Rate
A Fixed Interest Rate (or Fixed APR) is a rate that you agree to for the entire period of the loan. If you agree to a fixed rate loan, you can be certain that your payments will not change during the loan period.
Adjustable Interest Rate
An Adjustable Interest Rate (or Variable APR) is a rate that changes over time. There is usually a low fixed interest rate for a defined period, and then the interest rate changes according to how the market is doing. The bank will usually add a fixed amount called the Margin to a rate that’s referenced from another source. The source will usually be available nationwide, such as the U.S. Prime Rate. This means that if the market is doing extremely well, the Prime Rate will fall, and your interest rate will fall in turn. However, if the market is doing poorly, the Prime Rate will increase, and your interest rate will increase as well. The amount of times per year that your interest rates will change is entirely dependent on your loan agreement. Some banks will update the interest rate monthly, and others will update once per season.
|What are simple and compound interest? Are they important?
The choice between Simple and Compound interest don’t usually come into play with loans, because compound interest makes more money for the banks, so they tend to use that almost exclusively for loans. Simple interest is rare in terms of loans, but can be useful to understand. You can find out more by visiting our Interest page.
Types of Loans
There are various types of loans to meet various types of needs. They can commonly be broken down into housing/building purchases, car purchases, college debts, and personal purchases
Car loans are fairly straight-forward: a loan for a car, where the car is collateral. These can be procured at any bank, but many car dealerships will set them up for you. This can often be beneficial, because the car dealership may have worked out lower interest rates with the bank first.
|There are other various types of vehicle loans, ranging from boats, to motorcycles, but most of them function the same way as a car loan.|
Mortgages are loans for buying a building, usually houses, but they are also used for buying business buildings, farms, and other structures. Mortgages can be found with a bank (conventional), or can be found through one of several government programs (government-insured). The terms “mortgage” and “home loan” are often used interchangeably, but home loans cannot be used to buy a business building or farm. For each of these loans, you can either get a Fixed Rate Mortgage (FRM) or an Adjustable Rate Mortgage (ARM).
|Generally speaking, to obtain a mortgage, your income needs to be 3 times the amount of what your monthly payment would be. This is to ensure that you have enough money to support yourself (2/3 of your income) while paying your mortgage regularly (1/3 of your income). This is outside of other costs, such as realtor fees, closing costs, or home insurance.|
These are standard bank loans. Shopping around is encouraged by the owners of this site, as different banks and institutions offer different rates of both types (Fixed and Adjustable). Finding the best deal will often require talking to several different banks and institutions. Many of them also offer specialized programs for farmers or businessmen who are looking to buy property.
Home Equity Loan
You can borrow against the equity of your home, but some banks may not allow equity borrowing, or your borrowing period may have passed. This period of time can be found in your original loan paperwork. Please see the section titled Equity above for more information.
These are loans that you can get through a bank that is “insured” by the government. Every bank offers these, but it is up to you to decide which you want. The bank can tell you which you are eligible for.
Provided by: Federal Housing Administration
The FHA’s Home Loan often accepts a lower down payment for a house. Made for first-time home buyer, the FHA loan is more accepting of less-than-stellar credit scores and higher debt-to-income ratios.
VA Home Loans
Provided by: Department of Veterans Affairs
The VA’s Home Loan is for Veterans and Active Service military members and their families. This loan has no down payment, and can be used to buy or build a house.
You can find eligibility requirements here: http://www.benefits.va.gov/homeloans/purchaseco_eligibility.asp
USDA/RHS Home Loans
Provided by: Rural Housing Service
The USDA offers Home Loans for low-to-middle income families outside of metropolitan areas, as an incentive to build up rural areas. This loan boasts 0% down payment, as well as comparable interest rates to current market. Make sure to ask if your location is available for a USDA Home Loan if you’re interested. This loan cannot be used for a Farm (see below)
Provided by: Small Business Association
A loan for businesses to help them purchase a business building.
Find information about small business loans here: https://www.sba.gov/offices/headquarters/oca/resources/5991
Provided by: Farm Service Agency
There are several loans available for farmers and ranchers, including loans for farm equipment and incentive loans for minorities, youth, and women.
Find information about Farm Loans here: http://www.fsa.usda.gov/programs-and-services/farm-loan-programs/
Personal loans can be used for any personal reason you may have. Some examples of things people borrow personal loans for are:
- Honeymoons or Vacations
- Consolidating your credit card debts
- Buying large appliances, such as a washer and dryer, HVAC system, or a refrigerator
If you set down collateral, you will often lower the interest rate for your personal loan. Without collateral, however, you are basically asking the bank to simply trust that you can pay them back, and so they charge the highest interest rates for those loans, usually around 25-30%.
Specialized government-subsidized loans specifically geared for students who wish to pursue higher education (such as college, or university). Students can get their loans and more information through StudentLoans.gov. Parents of students can also apply for extra student loans for their children simultaneously through the same site.
For mortgages, depending on the amount you have to borrow, you may have to get a Jumbo Loan. Jumbo Loans are larger than usual house loans, based on median house prices for an area. The amount is defined by the government by county, but generally, anything over $417,000 will be required to take a Jumbo Loan. Because of the sheer amount that is being borrowed, Jumbo loans tend to carry higher interest rates and stricter credit score requirements.
Doing the Math
See our Example Home Mortgage page, which explains the number crunching aspect of loans.