A Beginner’s Guide to Loans
A Beginner's Guide to Loans
INTRO TO LOANS
Have you ever wondered how the heck loans work? Don’t worry, many adults don’t really know! The good news is, this post should help you better understand some of the lingo, concepts, benefits, and things to look out for when considering a loan. It’s never a good idea to commit to anything you don’t know much about so I highly recommend reading this post since you’ll most likely need use loans and probably already have student loans. Warning, there’s a lot to unpack here so I recommend re-reading this post a few times if you don’t get 100% of it the first time around.
First off, Why have loans? Loans allow us to purchase things without having the full purchase amount upfront. For example, most people don’t have enough cash to outright purchase a home, car, or pay for college. Loans are great because without them, it can take a lifetime to save up for large purchases. With loans you can purchase things with a downpayment (a partial, upfront payment), which can range anywhere from 0% – 25%+, and interest payments on borrowed money.
There’s a lot of loan related words that get thrown around which can make understanding loans difficult. It’s tempting to just trust the lender and hope that you’re getting fair loan terms but don’t be lazy, and don’t trust strangers! Learn the terms of your loans/loan offers, they can affect you for DECADES! **Note: The terms below aren’t in alphabetical order, but in order of basic importance.
Principal: This is the amount you owe to the lender, not including interest or other fees. It’s also known as principal balance or outstanding balance. As you pay off your loan, your principal balance decreases until finally, you payoff your total loan amount. For example, if you just purchased a $20,000 car with a 5 year loan, your current principal balance is $20,000. You’ve had paid off the car once your principal balance is $0.
Interest: This is the cost of borrowing money from lenders. It’s usually in the form of an annual rate. It is referenced as interest rate, rate, annual rate, effective rate, etc. This is how lenders make money off of you. (E.g 5% annual interest of the current principal balance)
**NOTE: Loan payments are often split between paying off the current interest due and part of the principal. For example, the monthly car payment for your $20,000 car with a 5% annual interest rate is $377.42, but only part of that amount is used to payoff your loan balance while the rest of the payment is used to pay for just interest. In the first month, $83.33 of the monthly car payment goes towards the interest you owe and the rest, $294.09, goes towards lowering your principal balance. In the end of the first month, your principal balance has decreased to $19,705.91 ($20,000 – $294.09 = $19,705.91). The interest you paid just goes straight to the lender for servicing your loan. In the first month ~22% of your monthly payment goes towards paying off the interest due (wows). Luckily, that’s the most you’ll ever pay towards interest since the beginning of the loan term is when your principal balance is the largest. As you pay down your loan amount, the monthly interest due for each monthly slowly decreases as well.
Annual Percentage Rate (APR): Usually, loans come with additional upfront charges such as an origination charge, processing fee, application fee, etc. This can make comparing different loan options confusing. Is an interest rate of 3.5% with no fees better than an interest rate of 3.2% with a loan fee of $300? Luckily the APR combines the interest rate and these additional fees to give you a true Annual Percentage Rate that you can use to compare different offers.
**EXAMPLE: In the previous car purchase example, since the car loan lender didn’t charge you any additional loan fees, the APR is the same as the annual interest rate, 5%. However, if another lender offers you an annual interest rate of 4.5% but with a loan fee of $500. You may think, niceee 4.5% is less than 5%, the 4.5% interest has got to be the better deal! However, if you factor in the upfront fee of $500, the APR is 5.54% which means overall, you end up spending more money with this offer.
Here’s a link to a simple APR Calculator & diagram of how to use it below!
**TAKEAWAY: Don’t just look at the interest rate, make decisions off the APR. Unfortunately, sometimes, depending on the lender, the APR doesn’t include ALL fees so take the effort to look over all the charges and ask questions if some fees are included in one loan estimate and not in another.
Co-signer/Co-borrower: If someone asks you to be a co-signer/co-borrower DO NOT agree right away. At the very least, take the time to understand what responsibilities come with becoming a co-signor/co-borrower. As a co-borrower you jointly own whatever is being purchased by your parent/friend/partner/etc. but you are also primarily responsible for keeping up with the loan payments. Becoming a co-signer means that you are responsible for whatever loan is being opened if the primary borrower (who is not you) can’t or decides not to pay for the loan – the kicker is that you have no ownership of whatever is bought. You might be thinking, well that’s whack, what if I just don’t pay? Sure, you can choose to do that, but lender(s) will go after you, your wages may be garnished (aka part of your wages will be taken until you payoff the loan), and your credit will significantly suffer. It doesn’t matter if your partner is now your ex-partner, if you had a falling out with your parent(s) or friend(s), or even if they died. Lenders want to be paid back and will go through a lot to make sure they are.
Downpayment: An upfront, partial payment made when purchasing a good or service. Typically when you purchase something with a loan, the lender requires you to put down a downpayment, usually 5% – 25%+ of the purchase price. A general rule of thumb is to try to put down a 20% downpayment if you can afford it. The good news is that the downpayment decreases the amount of money you need to borrow, which lowers your loan payments. For example, if you paid a 20% downpayment for your $20,000 car at 4.5% interest and $500 upfront loan fees, you would only have to take out a loan of $16,000. This would decrease your monthly car payment from $372.86 to $298.29 and decrease your overall finance charges by $474.36. Also, putting down a larger downpayment can improve your chances of qualifying for better loan terms (e.g. lower interest rate). So maybe, with a 20% downpayment and good credit, the lender offers you a 2-3% interest rate instead of 4.5%, which saves you even more money!
Prepayment Penalties/Fees: Sometimes, lenders put a “prepayment penalty clause” that punishes you with a fee for paying off your loan earlier than what you agreed to in the contract. They do this because once your loan is paid off, they no longer make any money off of you through interest. Bottom line, you should avoid any loans with prepayment penalties if you can and ALWAYS ASK THE LENDER IF THERE’S ANY PENALTY FOR EARLY PAYOFF!
**NOTE: The federal Truth-in-Lending Act (aka TILA) requires that borrowers receive written disclosures about the terms of any loans they are legally bound to prior to signing up for the loan. So if you don’t know the APR, finance charges, full amount of the loan, number of payments, late fees, monthly payments, pre-payment penalties, or ANY other loan related terms don’t be afraid to ask your lender!
Amortization: This is the process of dividing a loan into a series of fixed payments so that at the end of the loan term, the entire balance is paid off. The most popular types of amortized loans are home mortgages and car loans. These types of loans are usually paid over the course of 5 yrs for cars and 15-30 yrs for home mortgages. While the monthly payments are the same throughout the loan’s life, the amount paid towards interest is much higher in the beginning of the loan because that’s when the loan amount is the largest. In our previous car loan example, the loan was an amortized loan since after making 60 monthly payments of $372.86 the car is fully paid off.
**NOTE: You can use amortization calculators to see a monthly/yearly amortization schedule. As you can see in the amortization calculator example, the amount of interest you pay every month decreases as the principal balance decreases.
Refinancing: When you refinance a loan, you’re basically taking out a loan with another lender that will payoff your current loan. Why would you consider refinancing a loan? Because the new lender offers you better/different terms. Maybe you took out a mortgage loan when interest rates were around 5% and now, the average interest rate is around 4%. That 1% difference can save you THOUSANDS or maybe even TENS of THOUSANDS of dollars over the life of the loan. However, because most loans come with those pesky loan fees, it may not be worth it to refinance even if the interest rate is better (see below).
**Important Refinancing Notes**
- Refinancing can increase your loan payoff timeline: Refinancing your loan can increase your payoff time. For example, say you’re 15 years into your 30 year mortgage, you may be paying less mortgage per month but if you refinance with another 30 year mortgage you’ll be extending your mortgage another 15 years. Of course you can refinance with a 15 year mortgage or decide to pay more than your monthly mortgage amount to finish more quickly, but it’s something to keep in mind.
- Refinancing might not be worth it: Typically, refinancing a loan isn’t free. With mortgages, there’s a lot of fees involved, which can total up to several thousand dollars. You usually have the option to increase your loan amount to cover all these fees but remember, you’ll be paying interest on that amount and in the long run, refinancing may not be worth it if the interest difference is .75% or less unless the lender agrees to cover all costs themselves.
- FAQ: Why would lenders refinance your loans?! I know it seems charitable, but actually, it’s all business baby. Lenders will refinance your loans because they have the funds to buy out your loans and are happy to take over to make extra cash from the interest they’ll be charging you.
TYPES OF INTEREST
Simple Interest vs Compounding Interest
Overview: The interest due is only based on the principal balance and the interest rate.
Overview: The interest due is based on the principal balance, interest rate, AND any previously built up interest that wasn’t fully paid off. Basically with compounding interest, you can end up paying interest on interest – Yikes. Interest can be compounded on a yearly, quarterly, monthly, daily, etc. basis. The more interest is compounded (think daily), the more it can cost you. The most common example is credit card interest, but personal loans may also come with compounding interest.
Simple vs Compounding Loan Scenario
Simple Interest Example
Formula = Principal Balance x Interest Rate x Time
Interest You owe after 3 Years = $10,000 x 10% x 3 = $3,000
Amount you borrowed = $10,000
Total Due in Year 3 = $10,000 + $3,000 = $13,000
Compounding Interest Example
Let’s say that the interest is compounded annually (only once per year). Remember, with compound interest, the interest that accumulates is added to the original principal loan amount and affects the interest due. Below is a compact formula that calculates the total due at the end of a loan term. Good News – You don’t need to remember the formula because you can Google the calculator, or Bing for you psychos out there, but for you nerds…
At the end of year 3 you owe a total of = $10,000(1 + 10%)3 = $13,310
NOTE: With compounded interest you owe $310 MORE than with simple interest!!
If you’re still confused here’s a year by year breakdown:
Compound interest can HURT because unpaid interest is added to your principal balance which increases your interest fees. After a few years, the interest can end up snowballing into something way more than what you anticipated. So pay your credit cards off in FULL every month!
Fixed Interest vs Variable Interest
These simple/compounded interest rates can either have fixed or variable rates. For example, credit cards usually have variable interest rates that are compounded daily and home mortgage loans usually have fixed interest rates that are simple, but this is not always the case.
Fixed Interest Rate
Definition: A fixed interest rate stays fixed or the same throughout the life of the loan. Usually, home mortgages and car loans have fixed, simple interest rates. So if you signed up for a 3.5% interest rate for your 30 yr home mortgage, the interest will remain at 3.5% until the mortgage is paid off or renegotiated.
Variable Interest Rate
Definition: A variable interest rate changes depending on another interest rate called an index rate, that is predetermined by your lender. The interest rate can change as much as every week or every year. Usually credit cards have variable, compounded interest rates.
Bonus: Home mortgages can also have variable interest rates. These type of mortgages are called Adjustable Rate Mortgages or ARM. These types of mortgages have interest rates that stay fixed for a pre-set time period and then can adjust after X number of years. For example, with a 7/1 ARM, the interest rate is fixed for the first 7 years and then can adjust every year afterwards until the end of the loan.
**NOTE: Generally, it’s better to have a fixed rate so you don’t have to worry about your interest rate potentially increasing significantly during the time you have your loan. However, sometimes you get super special offers you just don’t want to give up or don’t really have an option.
Rates Are Not Offered Equally
Those with good/great credit scores are offered prime rates while those with low/poor credit are offered worse rates or are sometimes even rejected. This is because those with a higher credit score have shown that they are not likely to default on their debts. A credit score of 700+ is decent, 740+ is very good, and 800+ is exceptional.
A seemingly small rate difference can add up to a LOT. This is especially true with larger loans like home mortgages. Even a half a percent difference can end up costing you tens of thousands of dollars over the life of your loan. For example, if you opened a 30-YR, $300,000 at 5% interest you can save over $30,000 by qualifying for a 4.5% interest rate. With a 4% interest, you could save ~$65,000!
Make A Loan Checklist
Understand what you’re getting yourself into. Like I said earlier, loans can be an awesome option for many of us who don’t have the income or rich parents to buy homes/cars in cash. HOWEVER, some loans come with awful terms and you need to take the time to understand what you’re getting yourself into before signing up for anything. Before signing yourself up for any loans ask about these loan terms:
Avoid Predatory Lenders/Payday Lenders
Some lenders will try to confuse you with fancy sounding words and terms that SEEM okay while trying to skirt over important things like we talked about before like APR. If anyone tries to sign you up for something you don’t understand or makes you feel stupid for not understanding certain terms, you get up and WALK AWAY. Never get pressured into anything! There’s plenty of car salespeople, lenders, and mortgage brokers.Of course, the reality can be that due to your poor credit or income you may not qualify for regular loans BUT that doesn’t mean you shouldn’t be treated disrespectfully. A classic line a car salesperson might ask you is “Just let me know what monthly payment you want.” Nope the Fork out of there if that person won’t tell you what the APR is. #TheGoodPlaceReference
AVOID PAYDAY LOANS AT ALL COSTS. You ever see those “PAYDAY LOANS, GET CASH TODAY!” shops? YEAH FORK THEM TOO! Avoid them like the PLAGUE. Sometimes these sleazy lenders charge 300% – 400%+ interest rates for short-term loans. That was NOT a typo, sometimes it really is triple digit interest rates! Here’s an NPR piece from Planet Money on these crappy lenders. I know sometimes things get a little desperate but trust me, signing up for these loans can turn a desperate situation into a spiraling hell situation.
Just Because You Can Doesn't Mean You Should
You have a limited amount of money to spend and it’s your choice on how you spend it, but whenever you’re about to take a loan out for something (whether it’s with a traditional loan or a credit card) you should take more time to think about if it makes sense for you.
For example, many Americans dream of being homeowners one day but not enough people think about what they can comfortably afford. Let’s say your yearly salary is $50,000 and you were thinking of taking out a loan of $300K to purchase your first home. You figure, you were paying $1,100 in rent before and a mortgage of $1,432.25 seems like a better deal since the difference is only $332.25/month. Also, with a mortgage, at least paying towards full home ownership instead of just giving away rent money to your landlord right?! In this example, what you should keep in mind is that your monthly mortgage is about 44% of your monthly salary after taxes and you haven’t even factored in property taxes and maintenance costs! And unlike a lease agreement, you can’t easily move out of your place after a year. What if you lose your job? What if you get a great job offer across the country? What if you realize you like eating out and traveling more than being a homeowner, but your fun budget had to shrink for your home budget? What if your heater broke in the middle of winter and as a homeowner you have to dish out thousands to fix it yourself? Just because you can, doesn’t mean you should take out that loan for a home, a new car, etc. If it makes sense for you and your current life situation, by all means go for it but don’t let society, friends, family, etc. dictate what’s right for you because it’s what people “do”.
You don’t have to get your loan from the first person you meet. Whether you’re buying a car or home, or looking to refinancing your student loans, you should shop around with different lenders to find the best deal for you. It takes more effort but in the end you can save yourself a lot of $.
Important: Typically, if you apply for a loan, the lender makes what’s called a “hard credit pull”. Hard credit pulls lower your credit score temporarily, but if multiple pulls are made within a short period of time(15-30 days) for mortgages, auto loans, or student loan inquiries they are lumped together as just one hit against your credit score. However, this is not the case for all inquiries like credit card inquiries. So, you shouldn’t go shopping around for a credit card because each time you apply to one, your credit score will take a hit. For credit cards, do your research before officially applying and only apply if you are pretty confident you’ll be accepted.
- Make sure you make timely payments every month by setting up automatic payments. This way, you don’t have to worry about the due date, just make sure you have enough funds to cover everything every month.
- Have multiple loans with different interest rates (like student loans)? The best method is to at least pay the minimums for each loan, and if you have enough to make extra payments, put it towards the loan with the highest interest rates first. This method can save you lots of $ over time since you’ll end up paying less interest.
- Having difficulty finding the motivation to payoff your loans? Try to start by paying off your smallest loans first and working your way upwards. It’s not the most efficient way but if it helps keep you motivated it’s 100% worth it!
- If your current interest rates are higher than the typical rate for that type of loan, consider looking into refinancing your loan. The lower interest can help speed up the payoff timeline, but remember, shop around for the best rates!
- Loans can feel like a big headache to understand but the fact is, the majority of us have to take out a loan sometime in our life. Being an informed borrower can save you thousands of dollars and a LOT of potential headaches. I know this post is longer than others, but I really think it’ll be worth your while to try and at least skim the whole thing!
- Annual Percentage Rate AKA APR is the annual interest rate that includes the loan fees. Compare loan offers by looking at the APR, not just the interest rate.
- If your interest rate is notably higher than the current, average interest rate you may want to look into refinancing your loan to save yourself $.
- Before signing yourself up for any loan make sure understand your loan terms. Go over the basic loan checklist and make sure to shop around for the best rates you can qualify for! Also, if you’re thinking about co-signing a loan with anyone, understand this means that you’re on the hook for that person’s loan and their loan payments if they default.
- Try your best to avoid predatory lenders like payday lenders! They might sign you up for ridiculous rates that can range from 30% – 300%+ interest! Sadly, I’m not joking about the 300%+ interest.
- Lastly, just because you can qualify for a loan doesn’t mean you should! You should examine your personal situation before signing up for a loan. Understand the responsibilities that come with a loan, the cost of the loan, and if you even want the loan or if you feel pressured to get one for a home, car, etc. that you don’t really want.
**Disclaimer: I am not a licensed financial advisor nor planner nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. I’m not a finance professional through formal education. I just do this for fun, because I’m a weirdo. You should always verify everything before making any decisions! Link to my fancy disclaimer page: https://meandmypf.com/disclaimer/