The world of loans and lending can be very confusing for newcomers. In addition to the anxiety of trying to find a good loan, that will allow you to buy what you need, you’ve most likely found yourself bombarded with terms, statistics, and numbers that you not only don’t see how they relate to what you’re trying to do, but that you may not even understand.
There are few facets in life where it’s as important to do your research, and gather your facts, beforehand, as shopping for a loan. Though a loan can get you money when you need it, a loan is a serious commitment that you’ll be bound to under contract, and will obligate you to certain terms and conditions that you’ll have to abide by. It can affect not only your current financial standing, but your future financial endeavors as well.
To help you start your loan shopping experience off on the right foot, the following are six critical terms that you’ll need to know and understand, because you’ll encounter them, no matter which lender you ultimately decide to work with.
Principal
The principal of a loan refers to the total amount that the lender extends to you, or, in short, the total amount that you borrow. If, for example, you wanted to purchase a new car, and that car costs $26,000, you would need to borrow at least $26,000 in order to afford it. Your principle in this case would be $26,000.
Bear in mind that the principal is only the total amount that you borrow. Principal does not take into account any associated fees that you pay, nor does it include the interest, which we’ll cover next.
Interest
The interest on a loan is the amount that you have to pay the lender in exchange for giving you the loan, in addition to your principal. Interest is how lenders make a profit and stay in business. Without interest, lenders and credit agencies would never do anything more than break even with every loan.
The interest of a loan is probably one of the most critical terms you need to understand and research, because a loan that seems great on the surface can ultimately turn into a poor investment, if the interest is extremely high.
For example: let’s say the lender you worked with for that $26,000 car loan charges 25% interest on your loan. Twenty five percent of $26,000 is $6,500. So, in total, you would have to pay the lender $32,500 back for your loan.
Interest rates vary widely from lender to lender, and are based not only on the lender’s own policies, but also on the next critical term we’ll cover, which is your credit score.
Credit Score
Your credit score is a number between 300 and 800 that serves as a quick indicator of your level of trustworthiness. The higher your number, the better your score, and the more lending options that will most likely be available to you. The most commonly used score that the three major credit agencies use to check your score is your FICO score.
In general, you can break down credit into four categories: poor, fair, good, excellent. Poor scores generally fall anywhere from 300 to 550, fair credit ranges anywhere from 550 to 650, good credit between 650 and 730, and excellent credit ranges from 730 to 800. Keep in mind – these are not hard and fast ranges, and what one lender may consider good credit, another may only rank as fair, so you should only use these figures as a reference, and ask for an honest assessment when you shop.
Though it seems obvious, it bears emphasizing: get your credit score as high as you possibly can before you pursue a loan. A poor or fair credit score does not mean you’ll never get a loan, but most of the time, a better score will allow you to borrow more money, and enjoy lower interest rates and better terms.
Unsecured Loans
There are many types of loans available, for a wide range of uses. Mortgages are used to purchase homes, while car loans are used to buy cars, so on and so forth. In addition, there are subcategories of loans that will play a big role in determining not only how much money you can borrow, as well as the applicable interest rates, but whether or not you’ll get a loan in the first place.
An unsecured loan is a type of loan in which all the lender has to ensure they get their money back from you is a contract and your word. Normally, unsecured loans don’t require any type of assurance, other than your written signature, that you will pay back the loan in full.
While unsecured loans are the least risky for you, they are sometimes harder to qualify for, and usually have very strict life cycles (the amount of time you’re alloted to pay them back), and lower limits on how much you can borrow. It’s especially important that your credit score is as high as possible for an unsecured loan, to help you qualify for one, as well as receive better terms.
Secured Loan
In contrast to an unsecured loan, a secured loan is a type of loan in which something of value is promised to the lender, in the event that you default on your loan. With a secured loan, the lender has alternate forms of value to draw from if you don’t make your payments.
There are various methods used to secure a loan, including a down payment towards the total amount, but more often than not, a secured loan will involve some type of collateral, which we’ll cover next. In general, secured loans are easier to qualify for, and have higher limits, because there’s less risk on the part of the lender that they won’t get anything back if you default on the loan.
Collateral
Collateral refers to something of value that you own, that you promise to give to the lender, in the event that you default on your loan. Collateral can include anything that would allow the lender to recover their losses from a default loan, including the item the loan may have been used to purchase.
For example: if you take out a loan from someone other than the dealership to finance the purchase of a new car, and you fail to make your payments, the lender could take possession of your car, and sell it to cover the remaining balance.
Be extremely cautious before you enter into a loan with any type of collateral. If you’re secure in your finances, and know you’ll have no trouble paying the loan back, collateral can help you get better terms than you normally could. However, if you’re not absolutely sure you can cover your loan repayments, the obvious risk to you is that you lose your collateral, which will leave you in a much worse position than if you’d never taken the loan in the first place.