What is a Loan and How Do Loans Work?

Are you looking to learn more about loan basics, including answering the question, "what is a loan?" Then you’ve come to the right place! 

The Check City Loans 101 section of the Cash Academy blog is where we talk all about loans, what a loan is, different kinds of loans, and the ins and outs of how loans work.

So, if you’ve ever wondered, "What is a loan?" or "How do loans work?" this article will help.

What is a Loan?

A loan is a financial product that provides a form of credit to the borrower. It’s a type of credit in the form of a lending agreement that lets a borrower borrow money from a lender. 

There are many types of loans to learn about when learning the answer to "What is a loan?" Like the difference between secured vs unsecured loans, fixed vs variable loans, prime vs subprime loans, and installment vs short-term loans.

Secured vs Unsecured Loans

Secured loans require you to list something as collateral in case you cannot repay your loan, while unsecured loans do not require collateral. For example, with a mortgage, the home that you purchase is collateral. If you default on your mortgage, the lender has the right to seize your home to repay the debt.

Fixed vs Variable Rate Loans

Fixed-rate loans have an interest rate that won't change over time, while variable-rate loans have an interest rate that fluctuates with the market.

A fixed-rate loan is probably right for you if you prefer predictable monthly payments that can never go up. However, a variable-rate loan may be suitable for borrowers who are comfortable taking risks because they may see their interest rates decrease at times.

Installment vs Short-Term Loans

Short-term loans must be repaid quickly, typically within a few weeks to a year. While they might be good for emergencies in some situations, they are only available in small amounts, and interest rates may be higher than traditional loans. 

On the other hand, installment loans usually have longer loan terms. Installment loans are an excellent tool for improving your credit, but they are a long-term commitment that can become problematic if you default.

Common Loan Terms

Along with the many types of loans there are, there are also many common loan terms you might encounter when searching for a borrowing method that meets your financial needs. Here are a few of the most common terms you should know to get a loan:

• Loan Application: The form you fill out to request funds. The application may ask for information like your name, contact information, monthly income, property information, and more.
• Loan Term: The length of time you have to repay the loan.
• Loan Limit: The maximum amount of money you can borrow.
• Principal: The original amount borrowed, before interest and other fees.
• Interest Rate: A percentage charge applied to the outstanding balance.
• Loan Payments: The minimum amount you have to pay on your scheduled payment due dates.
• Collateral: Something offered to secure a loan in case you cannot pay back what you borrowed.
• Loan Fees: Potential additional costs like origination fee, servicing fee, insufficient funds fee, or late fees. You might be charged these fees throughout the underwriting process, throughout your loan term, or if you miss payments.

How Do Loans Work?

Now that we know the answer to "what is a loan?" and "how does a loan work?" it's important to point out that all loans follow a basic process that includes an application, rejection or approval, and terms and conditions outlining things like payment and interest rates. 

Depending on the financial institution and the borrower's credit history, this process may look different. But many loans may follow similar steps to the five outlined below: 

Step 1: A Potential Borrower Applies for a Loan

After researching which lender is a good fit for you, you can fill out a loan application. Many lenders now have online applications to make the process easy and convenient. 

In general, you may need to provide your name, date of birth, Social Security number, address and contact information, an ID, requested loan terms and amount, purpose for the loan, income information, or housing information.

Step 2: The Lender Reviews the Loan Application

This review period is known as underwriting. During the underwriting process, the lender is responsible for verifying your information. They may request further documentation, such as pay stubs, employment verification, bank statements, etc. They may also run a credit check to see your payment history and any outstanding debts. 

This information helps the lender determine your debt-to-income ratio so that they can be assured you can repay your loan. Sometimes, they may also request collateral to secure the loan and reduce the lending risk.

Step 3: The Lender Approves or Rejects the Loan Application

After the lender reviews your application, it will be either approved or rejected. If you meet the lender's eligibility requirements and get approved, you’ll get the funds you need and move on to steps 4 and 5. 

However, if your loan is denied then you won’t be funded the amount you wanted to borrow. In this case, the lender will generally provide a reason for the denial. Then, you can begin to take steps to fix the issue.

Step 4: The Lender Funds the Borrower the Loan Amount

How loan funds are given to borrowers depends on many factors, like the type of loan, the lender, the loan amount, preferred deposit methods, and more. A borrower could receive loan funds through a check, direct deposit into an account, or even cash. 

Some loans are for specific purposes, such as mortgages. In this situation, money is not funded directly to the borrower. Instead, the lender makes a large payment on behalf of the borrower, and the borrower then repays the lender. 

Step 5: The Borrower Makes Regular Payments to Pay Off the Loan

Now it’s time to enter the repayment period. Your loan may require monthly payments for larger loans or weekly payments for smaller loans. 

When you borrow money, it is important to remember that there will be a cost to this transaction. Every lender is different, but many lenders charge additional rates and fees on top of loan payments.

Reasons to Use a Loan

With various loan types, borrowing amounts, and lenders, you're likely to find a loan that can be used for just about any reason. Some of the most common reasons to use a loan include:

• Managing emergency or unexpected expenses, such as medical bills or living expenses after a layoff.
• Breaking up large purchases. You might use loans to buy homes, cars, boats, personal items, furniture, and other expensive items.
• Financing life events, like weddings, vacations, or funerals.
• Funding your education. Many student loan options are available through public and private lenders.
• Starting a business, scaling a business, or maintaining a business.

How to Get a Loan

Each lender will have varying requirements, but all of them are likely to take into account the following factors:

1. Credit History: Do you have a good credit score? Do you make payments on time? How much outstanding debt do you have currently?
2. Capacity: Do you make enough money to make your monthly payments? Do you expect to be able to make payments consistently in the future?
3. Collateral: Do you have any assets that could be used to repay the debt if you default?
4. Capital: Can you make a down payment for large purchases? Do you have any savings or retirement accounts that can be used if you lose your income?
5. Conditions: How will you use the loan funds? What kinds of loan terms are you requesting? Are there any additional factors that will increase the lender's risk?

If you are comfortable with your credit and income, you can begin researching lenders that offer the specific type of loan you need. Once you’ve compared and learned about your options, it’s as easy as filling out the application.

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