Taking out a loan is kind of a rite of passage of adulthood.
You may need to secure a student loan to secure financing for college next year. An auto loan may be necessary if you’re starting your first job and commuting every day puts you at risk of being chronically late. If you’re starting a family and want to move into your dream home, you’ll probably need a mortgage.
If you’re currently going through a rough patch, getting a personal loan may be able to help you out.
To put it simply, there are many different reasons people may need loans.
However, you can’t just show up to a bank or a credit union and sign up for a loan without making any preparations beforehand. As experts in the finance industry such as Barron Advisors caution, you can get yourself into more trouble if you get a loan without understanding the terms of it first.
In this article, we will highlight some of the most important terms usually found in loans so that you know what exactly what to expect if you decide to get one.
Secured and Unsecured Loans
When you’re looking for a loan, you will inevitably be asked if you are seeking a secured or unsecured loan.
One thing worth noting here is that you may not even have the chance to choose between getting a secured or unsecured loan depending on the institution and the purpose of the loan.
If your credit rating is not in a good spot when you’re trying to get financed, chances are the person or company on the other side will only be open to offering you a secured loan. With a secured loan, you have to offer some kind of collateral to be approved.
Auto and mortgage loans are typically the ones that require collateral, as the amounts are much higher, and therefore, the loan poses more of a risk. In the case of an auto loan, it’s often the vehicle you’re seeking financing for that is used as the collateral. For mortgages, the property itself is typically what becomes the collateral you forfeit if you fail to make payments.
Unsecured loans require you to offer no asset as collateral, which is why they are typically more appealing to the borrower.
Next up is the interest rate, and this is what Brown University terms as “the cost of borrowing money.”
When trying to get a loan, it is absolutely essential on your part to find out right away what the interest rate is. The interest rate is usually why you hear people shopping around before they get any loan because they want to secure the lowest rates available.
Several factors will help determine what the interest ultimately turns out to be on your loan agreement. This includes the principal – the total amount of money you’re borrowing – as well as the repayment plan that you and the borrower agree upon. The amount of time you need to pay back the loan factors into the equation too.
One more thing you need to check when you’re looking at the interest is to see if it’s a fixed rate or a variable rate. There is no clear cut better option between the two, so you’ll have to let your preferences and market factors guide you here.
Fixed rates are good because they enable you to prepare long-term for the payments you have to make, but they are less flexible and will not allow you to take advantage of dropping interest rates.
Variable rates can lower your loan payments if interest rates fall, but then again, your debt may also grow if the rates rise.
Let’s say that you’ve come into some unexpected money because you received an inheritance or got a lucky lottery ticket and won a few thousand dollars. You may think to use that money to pay off your loan, but before you do so, consider the prepayment penalties.
A prepayment penalty is a fee you must pay if you want to pay off your loan obligation early. It may seem counterintuitive for borrowers to penalize you for paying early, but as The Balance notes, some loans are simply designed to last for a certain amount of time.
It is worth pointing out that prepayment penalties are not baked into all loan agreements. If you would rather not deal with this, look for a loan agreement without one or try to negotiate it out before you sign your approval.
We’ll finish by discussing one more type of loan, one that may be offered to you if you’re attempting to secure financing for your home.
A balloon loan is a loan in which you will only be on the hook for paying off the interest during the first few years of the agreement. Obviously, that means you’ll have to make smaller payments.
The potential problem with a balloon loan pops up when you are asked to pay off the principal amount in one large balloon payment. According to The Motley Fool, lenders often ask borrowers to pay off the principal amounts on balloon loans three to seven years after the loan was initially taken out.
You may find it easier to keep your head above water early on by getting a balloon loan, but you have to be prepared to make that balloon payment when it comes due.
Financial experts such as Barron Advisors are always quick to remind people that getting a loan should not be taken lightly. It’s a process that you need to take seriously and study carefully if you want it to be beneficial instead of something that buries you.
By remembering the things mentioned above, you will be better prepared when the time comes for you to take out a loan.