Beginner's Guide to Loans
Learn the basics of borrowing
Exploring the world of loans — whether they’re familiar or still alien to you — doesn’t have to leave you feeling spaced out. From personal loans to auto loans (and everything in between), here’s how to make sense of it all.
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Loans can help with everything from starting a business, going to school or just feeding your family.
But if you’re not careful with your borrowing, taking out loans can cost you big time.
While the allure of extra money can be enticing, not understanding concepts such as credit and interest can lead you to take on unnecessary debt, or spiral further down the rabbithole.
Before you leap into a loan, learn about all the different types. We’ll help you figure out which works best for you without having to worry about whether it’ll cost you an arm and a leg.
What is a loan?
Simply put, a loan refers to the act of borrowing money from a financial institution like a bank, credit union or from an online lender. Borrowers get access to a set sum and are expected to repay it — typically with interest on top.
When you need to borrow money, you won’t always get to choose which type of loan you get. If you do get to choose, the right decision for you will depend on accessibility, cost and responsibility.
Secured vs. unsecured loans
A loan is considered “secured” when you put up some form of collateral: an asset that the lender can seize and sell if you fail to make your payments.
That collateral might be your house, your car or your savings. If you are unable, or unwilling to pay your debt, a lien — or legal claim — can be placed on your asset, giving the lender confidence that it can get its money back.
The most common secured loans are mortgages, auto loans, home equity loans and home equity lines of credit (HELOCs).
If you don’t have collateral for a loan — or don’t want to put any up — you can only apply for an unsecured loan.
Because you don’t have something on the line should you ever default, unsecured loans typically come with lower borrowing limits and higher interest rates.
Unsecured loans can be easier for those with bad credit to access, but without collateral, you’ll find borrowing money much more expensive.
The most common unsecured loans are credit cards, personal loans and student loans.
A personal loan is a basic form of borrowing that can be helpful for all kinds of goals, like renovating your home, going to the dentist or even freeing yourself from heavy debt. The process is simple: You borrow a lump sum from a bank or online lender and then pay it back in fixed instalments, with interest on top. In most cases, you’ll have two to five years to pay it back at a fixed, simple interest rate. Once you pay off your loan in full, the account closes.
2. Credit cards
A credit card is a form of revolving debt. When you open a card, you’re given a credit limit. This limit is a fund you can borrow from as many times as you want. Whenever you pay your bills, it frees up the funds so you can borrow more. Unlike the fixed timeline of a personal loan, you’re able to borrow with a credit card (and stay in debt) indefinitely.
3. Lines of credit
A line of credit is a borrowing option offered by financial institutions that provides you with a credit limit you can use and reuse, based on your needs. Think of it as a credit card without the piece of plastic for your wallet. As with a credit card, you pay interest only on the money you actually borrow, not on the entire line of credit you received. And the interest rates are usually much more reasonable compared to credit cards.
An auto loan is exactly what it sounds like: a loan you take out to afford to buy a car. The average price for a new vehicle hit a record-high of $48,182 in July 2022, according to Kelley Blue Book. Since most people don’t have that kind of cash handy, that means having to take on an auto loan. Like personal loans, this type of loan comes with a set term, monthly payments and an interest rate. Once you’ve paid off the loan, the car is officially yours.
6. Home equity loans
A home equity loan is a "second mortgage" that you take out in addition to your primary home loan. It allows you to borrow against your equity in one big chunk, with a fixed interest rate. After the loan closes, the lender either cuts a check for the lump sum or wires funds to your bank account. You then repay the loan over time, often 10 to 30 years, in equal monthly instalments. It’s a good option for homeowners who prefer predictable payments.
Home equity lines of credit, or HELOCs, are a revolving credit line that usually comes with a variable interest rate. The lender approves you for a specific amount of money — the line of credit — that you can borrow from on demand against the equity in your home. As with a credit card, you pay interest only on the money you're using. You’ll have “draw” and “repayment” periods where you’re allowed to pull what you need from the account for a set amount of time and then another set period of time where you’ll be expected to repay what you borrowed. And because the interest rate is variable, your payments can fluctuate.
You may be wondering if we missed payday loans on our fairly exhaustive list.
Also known as cash advances, or short-term loans, payday loans give people with poor credit and a lack of funds access to fast cash. But they also come with incredibly steep fees — the Consumer Financial Protection Bureau says you can expect to pay $10 to $30 for every $100 you borrow.
Many financial experts would caution against relying on these short-term loans as they can keep people in a cycle of debt. They should only be used as a last resort and with the understanding that it’ll cost you much more than you get in return.
Where to turn when you’re cash-strapped
Loans are great when you want to make a big purchase, but they can be a lifesaver when you need money ASAP.
But how do you know which type of loan makes the most sense for your situation and needs?
Personal loans and credit cards are both useful in these situations but there are a few key differences between these two options.
Understanding the appropriate times to use each of these forms of credit can help you organize your finances and pay as little interest on your debts as possible. Here are a few examples of when each option makes the most sense for borrowers.
You get access to a low annual percentage rate. Interest rates for personal loans vary widely — from 6% to 36%. The rate you’re eligible for is determined by your credit history, debt-to-income ratio, employment status and other factors that measure your creditworthiness. The less risk you present as a borrower, the better the rates you’ll find.
To finance a significant, one-time expense. Many personal loans have a one-year minimum term, so they make sense for large purchases that will take longer than a year to pay off. If you use a personal loan for something you can repay in less than a year, you’ll end up paying unnecessary interest.
You can take on another monthly payment. Take a look at your current finances. If you add another debt to the list, will you have enough at the end of the month to comfortably make the payments? The last thing you want to do is default on your loan as missed payments will tank your credit score.
You’re making smaller purchases. Each time you swipe your card, you’re essentially approved for a mini-loan. You can take out as many of these mini-loans as you want until you reach your credit limit. Then, when you pay off those mini-loans, you can continue borrowing more. This revolving debt system makes it convenient for smaller purchases and everyday spending.
You can get a special rate. Some credit cards offer introductory interest rates of 0% that can last from six to 20 months. You can essentially borrow money for free during this period. If you use these cards to consolidate small debts, or for larger purchases that can be paid off during the introductory rate period, you’ll save money on interest.
You can afford to pay off your balance quickly. Unless you’re taking advantage of a 0% APR offer, you should use a credit card only for expenses you can repay in full each month. Carrying a balance from month to month is an extremely expensive way to borrow money.
Homeowners have other options, too
If you own a home and you’ve built up some equity, you’ll be happy to hear you have even more loan options.
That’s because, in addition to the choices above, you can also take out one of two types of loans that allow homeowners to borrow against their home’s equity.
Home equity loans and home equity lines of credit (HELOCs) are a way for homeowners to tap into the equity of their homes to help fund a major expense, such as a home renovation or a child’s education.
They are considered second mortgages and secured loans, with your home put up as the collateral. But the way you access money — and how you’re expected to pay it back — make these two very different products.
Home equity loans
After the loan is approved, your lender either cuts a check for the lump sum or wires funds to your bank account. You then repay the loan over time, often 10 to 30 years, in equal monthly installments.
Your interest rates are also fixed, which means your payments won’t change over the life of the loan. And because your home is used as collateral, these loans tend to have lower interest rates compared to their unsecured counterparts.
The interest may also be tax-deductible. If you use the loan to "substantially improve" your home, the IRS allows you to deduct the interest payments on your taxes.
However, keep in mind that this is a “second mortgage.” Like a first mortgage or a refinance, home equity loans come with closing costs. These are usually equivalent to 2% to 5% of the loan amount, and you may choose to roll the costs into your loan amount.
Most HELOCs allow you to borrow from the account during a draw period, usually around 10 years, using checks or a credit card tied to the account. Once you hit your credit limit, you can pay down the line and borrow from it again. As with a credit card, you pay interest only on the money you're using.
At the end of the draw period you enter the "repayment period," typically 15 to 20 years.
The great thing about HELOCs is you might not know upfront how much money you want to borrow, but these loans allow you to withdraw what you need, only when you need it. Some lenders even waive closing costs and fees, though you might need to meet eligibility requirements.
But because your interest rate is variable, it could increase anytime — and so will your payments. Plus, depending on the lender, you may pay annual fees, transaction fees on each withdrawal and closing costs. Some even come with a balloon payment, where you make one large payment toward the end.
How does refinancing a loan work?
Refinancing a loan, whether it be your mortgage or student loan, is essentially trading in your debt for a new one.
Here’s how it works: you take out a new loan (likely at a more advantageous interest rate or term) and pay off your old loan. From there, your original account should be closed and you’ll make your payments to your new lender.
There are many good reasons to refinance debt, like getting a better interest rate that allows for lower monthly payments, freeing up some cash by switching to a longer term, consolidating multiple debts or switching from a variable interest rate to a fixed rate.
Having trouble getting out from under your debt?
Credit cards are notoriously expensive. If you’re having trouble getting out from under your debt, you may want to explore your consolidation options.
Especially if you’re carrying balances on multiple cards, a personal loan can reduce your interest rates and simplify your finances by leaving you with a single, fixed monthly payment.
And compared to credit cards that have low monthly payments that essentially give you the option to extend your debt forever, personal loans come with a set end date. If you want accountability and pressure to pay off your debts by a certain date, the fixed nature of a personal loan can help.
Consolidating credit card debt with a personal loan
Flexible with few limitations on what they can be used for.
Lower average APR than credit cards for borrowers with excellent credit.
No collateral is needed to secure a personal loan (unlike with home and auto loans).
Consolidation of multiple debts into one fixed monthly payment makes it easier to budget and manage finances.
You can access large sums quickly with convenient online application processes.
Interest rates can be higher than credit cards for those with fair or poor credit scores.
Some lenders charge fees and penalties for paying off a loan early.
Most lenders don’t allow terms of less than one year.
Higher monthly payments (compared to a credit card minimum payment) means having lower monthly cash flow.
May lead to credit card abuse and falling further into debt.
During the 2021-2022 academic year, tuition and fees hit an average $38,070 at four-year private, non-profit universities, according to The College Board.
So, for most Americans pursuing a higher education, student loans have become essential.
The federal government and private lenders offer several varieties of college loans to students and their parents, including direct subsidized loans, direct unsubsidized loans, direct plus loans and private loans.
A FAFSA might help you avoid loans altogether, because the form is also a gateway to grants, scholarships and work-study programs (where money given doesn’t have to be paid back).
But if you need to go the federal loan route, you'll find that they're relatively easy to get. A borrower typically won't undergo a credit check or need to find a co-signer.
However, the limits on federal loans can be a little convoluted.
Private student loans
Private student loans are offered by banks, and the application process is more complicated. The lender will want to check your credit and income, and will most likely require that a parent co-sign the loan.
Private loans have variable rates that can increase over the life of the loan, and the interest may not be deductible. By comparison, federal student loans come with fixed interest rates, and the interest may be tax-deductible.
You don't have to start repaying a federal loan until after you graduate, but a private loan often will require you to start making payments while you're still in school.
Direct loans for graduate or professional students
Direct Plus loans for parents, and for graduate or professional students
The interest you pay on a private student loan is usually higher than a government loan. However, if you have a good credit score or a strong banking relationship, you might be able to negotiate a lower rate.
Refinancing your student loans
Refinancing your student loan is just like refinancing any other type of loan: you take out a new loan with a lower interest rate, use it to pay off your existing debt. Then you start making monthly payments on your new loan instead.
It might seem like you’re just trading one debt for another, but refinancing into a lower rate could help you pay off your loan more quickly and save on interest.
Let’s say you owe $25,000 on a student loan with an 8% interest rate, and you have 15 years remaining in your term.
If you choose to refinance your loan to a 12-year term at 4.25%, you’d pay $17 less each month, pay off your debt three years earlier and save $11,046 in interest.
However it’s important to note that switching from a federal student loan to a private one does make you ineligible for special government support, like the COVID-19 freeze that saw payments paused for two-plus years. But if you have a private loan already, there's no such downside.
Getting a new car is a big decision. You can spend weeks (or even months) researching the latest features and test driving different models before you find the perfect ride.
But locking down the right car loan is just as important — aside from a mortgage, your car loan will likely be the biggest financial commitment of your life.
And yet, for some bizarre reason, a lot of buyers go with the first loan they come across. It’s a rookie move and one that could wind up costing you a pretty penny.
Say you took out a $20,000 loan for a seven year term. If you had an interest rate of 6.5%, you’d pay $4,947 in interest. But if you shopped around first and found a similar loan at a 5% rate, you’d only pay $3,745 in interest — and save more than $1,200.
Experts typically recommend comparing rates on at least three loans before settling on one that works for you.
And with more car dealerships and lenders offering up to 84-month auto loans, going for a longer term with smaller monthly payments may be enticing.
But the trade-off is you’ll generally end up paying more in interest over the life of the loan.
Let’s say you plan to take out a $20,000 loan to buy a new car. Assuming you have excellent credit, here’s how much you can expect to pay every month, along with how much you’ll have paid in interest by the end of the loan.
Car loan term
Total interest paid
Extending your term means paying more in interest
As you can see, the monthly payment on a 60-month loan is about $100 more a month than the monthly payment on an 84-month loan, but it also saves borrowers $1,200 in interest.
You could always try to pay back an 84-month loan sooner, but many lenders charge a prepayment fee for paying off your loan early, so it may not be worth it.
And unlike a house, vehicles almost never appreciate in value over time. So making a commitment to long-term financing is not a good idea.
We’d suggest if you really need a seven-year loan to buy your dream vehicle, it’s worth considering whether your dream car is out of your price range — for now, at least.
Whether it’s for a mortgage, an auto loan, or even a new credit card, having a good credit score is essential for getting any type of loan.
Your credit score is a rating that measures how good you are at paying back your debts. The score ranges from 300 to 850, and the higher your score, the better your rating is.
So how do you get the best possible credit rating? The simple answer is pay off your debts on time without accruing any interest.
If you have a credit card, use it, but make sure you make all your payments on time. If you can’t pay off your whole debt all at once, paying more than the monthly minimum is the second best thing you can do.
Just by using your credit card and paying it back shows how you manage your debts. To further demonstrate your fiscal responsibility, keep your credit use to within only 30% of your card’s maximum allowance. For example, if your card has a credit limit of $10,000, only use $3,000 of it at any time.
If you want to know what your credit score is, Equifax, Transunion, and Experian will all provide you with a certain number of free credit checks yearly. You may also have heard that simply checking your credit score will lower it, but this isn’t true.
Your credit score will be lowered if you make a “hard inquiry” for example, applying for a new loan. When you do so, the prospective lender will reach out to check your credit history. This can lower your score by several points and stay on your report for around 24 months. A “soft inquiry,” which doesn’t involve applying for any new loans or credit, won’t affect your score.
Simple interest is interest on a loan you receive, like a mortgage, auto loan, or a student loan. The interest charged is basically a way for the lender to ensure that they aren’t simply giving away free money.
You pay simple interest on the principal amount of a loan - that is, the amount you borrowed in the first place.
Let's say, you need a new car, and need a $10,000 unsecured loan to cover the cost. The bank approves this loan at an annual interest rate of 8%.
That means that for every year of the loan, you’ll have to pay $800 in interest. So if you have a two-year loan, you’d pay $1,600. For a three-year loan, it would be $2,400.
Compound interest is when you have to pay interest on the interest that you accumulate over the duration of your loan. Credit cards are one example of a service that uses compound interest.
Let’s say you have $1,000 debt on your credit card with a rate of 10% monthly interest. The first month, that $1,000 will rise to $1100. The second month that debt rises to $1,210, the next month $1,331. For every month that passes, you are charged interest based on the principal amount and any previous interest.
Compound interest is a great benefit when it comes to your investments, as you’re making money off of money. When it comes to debt, though, it means that you end up owing money on money you never had.
Sigrid’s current role is associate editor, and she has also worked as a reporter and staff writer on the Moneywise team.
In her time with the company, she’s written about everything from estate planning in your 20s to figuring out how much tile you need to renovate a bathroom. Regardless of the topic, Sigrid takes pride in demystifying complex financial issues and turning them into stories that help readers find the personal in personal finance topics.
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