Borrowing money should never be a decision that you make lightly. Whether you are refinancing a rental property or buying a new car, choosing a loan means entering into an agreement with a lender, and you should always be sure that you can uphold your end of the deal. There are many types of loans available for different purposes. Here are a few things you should think about before taking out a loan.
First, what do you need the money for? People take out loans for a variety of reasons, including buying a house, going to college, or paying medical bills. Here, we will detail a few of the common types of loans.
- Mortgage - A mortgage is a loan taken out in order to help you buy a home. The collateral for a mortgage is the home you hope to buy. If you fail to meet your mortgage payments, the lender (usually the bank) gains possession of the home.
- Student Loans - Student loans are taken out when someone needs money to pay for school, including tuition, room and board, or even school supplies. Most of these loans are given out by either the federal government or private lenders.
- Auto Loans - These are loans taken out to buy a vehicle, usually a car, but there are also loans for purchases of other vehicles as well. Similar to mortgages, the collateral is the car that you intend on buying. Defaulting on your loan results in you losing the car.
- Personal Loan - These loans are some of the most flexible in terms of what the money can be used for. Common uses for personal loans include medical bills, wedding expenses, home repairs, or even vacation costs. Although not typically recommended, some people even use personal loans to pay off other debt that is coming due before the borrower has sufficient funds to pay.
Every type of loan falls within two main categories - secured and unsecured. Whether you choose a secured or unsecured loan determines what you need to be approved for, what you are putting up as collateral, as well as your interest rates.
Secured loans include mortgages and auto loans. This means that when you take up the loan, you need to include a physical asset as collateral. For mortgages, the loan is secured by the home itself. In the case of auto loans, your car would be held as collateral. When taking out a secured loan, lenders often take into account your credit score, credit history, as well as the value of your collateral. Secured loans often have lower interest rates than unsecured loans, as you are risking one of your own assets if you default.
Unsecured loans do not require any asset to be used as collateral. Therefore, lenders base your interest rate solely on your credit score and history. Because you are not risking any of your own assets if you default, unsecured loans are much riskier for the lender. This is why lenders tend to charge higher interest rates and loan out smaller amounts for unsecured loans.
If you default on an unsecured loan, you will not lose any of your assets. However, the lender will report your loan default which will result in your credit score being lowered. A low credit score makes it far more difficult to be approved for loans in the future. Raising your score can be much more challenging and take more time than lowering your score, so it’s advised that you take every precaution to keep it high from the start.
Once you have figured out which type of loan is best for you and your needs, it is time to consider the terms of the loan. The four things you should consider when taking out a loan are the principal, interest, installment payments, and the term. Here is what each of these factors mean for you.
- Principal - The principal is the amount that you borrow. This should reflect what you are using the loan for and how much money it requires. As you pay back the loan, the more principal that you pay, the more equity, or ownership of the underlying asset, you are gaining.
- Interest - When a loan is paid back, you must pay back interest in addition to the principal. The interest is calculated based on the Annual Percentage Rate (APR). Higher APRs mean higher interest payments. Ideally, lower interest rates are best as that means you pay the least interest possible on top of the principal.
- Installment Payments - Loans are typically paid back to the lender in installments. These are usually fixed monthly payments. When you are viewing the installment amounts, make sure that you are able to meet these payments within the time periods specified. For instance, if you will owe $2000 a month, this should be a cost within your budget.
- Term - The term is how long you have to pay back the loan. This can range in time from months to years, depending on the type of loan and the principal. When you consider the term, be realistic. Is the term long enough for you to pay back the loan?
When choosing a loan, there is a lot to consider. Take your time in making this decision. There are many lenders, all of which will offer loans with varying terms. Figure out which loan is best for you. Depending on the loan, you could be stuck in an agreement with the lender for years, so make sure the terms of the agreement are compatible with your future plans as well.
Overall, loans can be a great way for you to reach your goals, whether it be owning a home or going to college. Don’t forget to think about the long-term effects of a loan. For instance, many people who take out student loans are still paying them back even years after graduating. In the end, before taking out a loan,do your research and be realistic about your ability to repay it. This will ensure the process is smooth and feasible.