Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.
What is a Loan?
If you have never received a loan to purchase something, you are certainly in the minority! Loans can be a great thing, but they can also get you into trouble. One of the keys to being financially successful is understanding when loans are a good solution for your situation. Loans are never a good idea if you can't afford to pay them back in the required time frame. Let's explore what a loan is and find out some of the common ways to borrow money.
A loan is when you receive money from a friend, bank or financial institution in exchange for future repayment of the principal, plus interest. The principal is the amount you borrowed, and the interest is the amount charged for receiving the loan. Since lenders are taking a risk that you may not repay the loan, they have to offset that risk by charging a fee - known as interest. Loans typically are secured or unsecured. A secured loan involves pledging an asset (such as a car, boat or house) as collateral for the loan. If the borrower defaults, or doesn't pay back the loan, the lender takes possession of the asset. An unsecured loan option is preferred, but not as common. If the borrower doesn't pay back the unsecured loan, the lender doesn't have the right to take anything in return.
Types of Loans
Personal loans - You can get these loans at almost any bank. The good news is that you can usually spend the money however you like. You might go on vacation, buy a jet ski or get a new television. Personal loans are often unsecured and fairly easy to get if you have average credit history. The downside is that they are usually for small amounts, typically not going over $5,000, and the interest rates are higher than secured loans.
Cash advances - If you are in a pinch and need money quickly, cash advances from your credit card company or other payday loan institutions are an option. These loans are easy to get, but can have extremely high interest rates. They usually are only for small amounts: typically $1,000 or less. These loans should really only be considered when there are no other alternative ways to get money.
Student loans - These are great ways to help finance a college education. The most common loans are Stafford loans and Perkins loans. The interest rates are very reasonable, and you usually don't have to pay the loans back while you are a full-time college student. The downside is that these loans can add up to well over $100,000 in the course of four, six or eight years, leaving new graduates with huge debts as they embark on their new careers.
Mortgage loans - This is most likely the biggest loan you will ever get! If you are looking to purchase your first home or some form of real estate, this is likely the best option. These loans are secured by the house or property you are buying. That means if you don't make your payments in a timely manner, the bank or lender can take your house or property back! Mortgages help people get into homes that would otherwise take years to save for. They are often structured in 10-, 15- or 30-year terms, and the interest you pay is tax-deductible and fairly low compared to other loans.
Home-equity loans and lines of credit - Homeowners can borrow against equity they have in their house with these types of loans. The equity or loan amount would be the difference between the appraised value of your home and the amount you still owe on your mortgage. These loans are good for home additions, home improvements or debt consolidation. The interest rate is often tax deductible and also fairly low compared to other loans.
Small business loans - Your local banks usually offer these loans to people looking to start a business. They do require a little more work than normal and often require a business plan to show the validity of what you are doing. These are often secured loans, so you will have to pledge some personal assets as collateral in case the business fails.
Advantages of Loans
Business growth and expansion - Loans are a great way for a business to expand and grow quicker than it otherwise could. Access to additional money helps businesses hire more employees, buy inventory and invest in needed machinery.
House and vehicle purchases - These purchases are expensive. Coming up with all the money to buy a house or car could take decades for people! Loans make it quicker, affordable and budget friendly.
Funding for education - The majority of individuals seeking a college education couldn't do it if they had to pay it all up front each year. Loans help people get the education needed to secure a job or career they desire.
Debt consolidation - Loans can be used wisely to consolidate other loans and debts. This process can help simplify someone's financial situation and can save them money on interest payments.
Disadvantages of Loans
Long-term debt - You may owe money to lenders for several years with a loan. That means you have to work extra hard to budget your cash appropriately. The payment and responsibility of large amounts of debt over several years can take a financial and emotional toll on a person.
Interest - Paying just the interest on multiple loans can end up costing individuals tens of thousands of dollars a year. One loan may be manageable, but add a house loan, two car loans, student loans and a few credit card advances into the mix, and the interest can get out of control very quickly.
Penalties and loss of assets - If you miss a few loan payments or are consistently late, not only will you pay interest, but you could pay an additional $30 or $40 a month in penalties or late fees. You do it too many times, and the bank or lending institution can legally take back your house that you have been paying on for ten years!
A loan is when you receive money from a friend, bank or financial institution in exchange for future repayment of the principal and interest. They can be unsecured, like a personal loan or cash advance loan, or they may be secured, like a mortgage or home equity line. Loans can be great for consolidating debt, paying for your education and growing your business. Be careful, though! Loans can also cause long-term hardship both financially and emotionally and be very expensive if you miss payments or enter into a loan you can't afford. Loans can be a good thing, but just make sure you do your homework first and understand what you are signing up for.
Notes on Loans
|Receiving money from a friend, bank, or financial institution in exchange for future repayment of the principal plus interest||*Personal loans
*Home equity loans
*Lines of credit
*Small business loans
| *Quickly grow a business
*Purchase a home or a car
*Consolidate a debt
|*Debts may take a long time to pay off
*Interest can become expensive
*Penalties can be imposed and assets can be seized if the debt is not repayed
When you are done, you should be able to:
- Explain what a loan is
- Describe the types of loans
- List the benefits and drawbacks of taking a loan
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