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.
A Case Study
To see how all the pieces fit together, let’s take a look at a sample loan.
Karen takes out a $10,000 loan with an interest rate of 8.25 percent and a 10-year term. Because this is a secured loan, Karen uses her 1967 Ford Mustang as collateral.
Karen’s loan breaks down as follows:
Loan Balance: $10,000
Loan Interest Rate: 8.25%
Loan Term (in years) : 10
Minimum Monthly Payment: $122.65
Total Payments: $14,718.49
Total Interest Paid: $4,718.49
The minimum monthly payment that Karen needs to make to complete her loan within the 10-year term is $122.65. After 120 payments of $122.65, Karen will have paid off her entire loan and $4,718.49 in interest.
Keep in mind that Karen can always increase her monthly payments. This will shorten her loan’s term and result in less interest paid. For instance, if Karen decides to pay $250 each month, her repayment plan breaks down as follows:
Loan Balance: $10,000.00
Loan Interest Rate: 8.25%
Monthly Loan Payment: $250.00
Number of Payments: 47
Total Payments: $11,734.15
Total Interest Paid: $1,734.15
By upping her monthly payment, Karen shortens the term of her loan to 47 months, or just under four years. She also reduces the total amount of interest she pays to $1,734.15.
Let’s say that, instead of upping her monthly payments, Karen skips a few. In fact, let’s say she stops paying the loan altogether. That’s bad news for Karen. Because this is a secured loan, Karen may be kissing her Mustang goodbye.
So when you consider taking a loan, pay special attention to the basic terms to anticipate how much you’ll pay and how long you’ll be in debt.
If you want to calculate how much your loan will cost you (and how much you’ll need to make to keep pace with your payments), check out the Loan Payment Calculator.