Loans 101: the Basics of Borrowing
By Mike Pugh
September 04, 2008
If you’re a current or future college student, chances are good that you’re considering a student loan. Before you make any decisions, it pays to understand the basic principles behind borrowing.
All loans consist of three components: The interest rate, security component and term.
The Interest Rate
The interest rate is the lender’s charge for the use of their money. The interest rate is usually a small percentage of the amount loaned.
There are two different types of interest rates: fixed or variable (aka adjustable).
Fixed rates are just that: fixed and unchanging. If your fixed interest rate is 7 percent, it will be 7 percent for the life of the loan.
Variable rates can change over time and are usually based on a standard market rate, such as the prime interest rate (which is the lowest rate of interest a bank can provide at a given time and place, offered to preferred borrowers). For instance, you may take out a loan with a variable rate at prime +2. This means that you’ll pay two percent more than the prime rate, regardless of what it is.
Interest rates for popular student loan programs like Stafford and Perkins Loans have low interest rates. Plus, the government pays the interest on subsidized Stafford Loans and Perkins Loans while you’re in school.
The Security Component
All loans are either secured or unsecured. This refers to whether you are putting up assets, often referred to as collateral, to guarantee your loan.
If you have a secured loan, it means you have guaranteed your lender will be repaid one way or another by giving them a claim on something you own. If the loan goes unpaid, the lender can seize the collateral to recoup their investment. This guarantee gives lenders a great deal of security and allows them to charge low interest rates.
Unsecured loans do not require any collateral from the borrower. The bank therefore has no protection if the loan goes unpaid. Unsecured loans almost always have higher interest rates than secured loans. Lending institutions sometimes require that an additional person co-sign for unsecured loans, or vow to repay the loan if the borrower fails to do so.
Student loans have an advantage in that no collateral is required but they still have low interest rates.
The term of a loan is the length of time that the borrower has to pay back the loan. Most personal loans have terms of one to five years. Many student loans have 10-year repayment periods. Typically, the longer the term, the higher the interest rate. The term is the maximum length of time the borrower has to repay their loan; loans can always be paid off before the term is up.