August 19th, 2019 | Updated on June 3rd, 2021
Excluding home mortgages, the average American carries just under $40,000.00 worth of debt. That debt covers everything from car debt to short-term renovation debt and beyond.
While $40,000.00 worth of debt might seem like a bad thing, in reality, debt is a helpful tool that enables people to keep their bank accounts cash-rich. Debt also helps people purchase lifestyle-improving things that they wouldn’t ordinarily be able to afford.
If you’re reading this article, we’re willing to bet that you’re considering taking on a loan and want to know more about how loans work. Below, we’ll walk you through every step of the loan process which will brief you on what’s worth knowing.
1. Assessing Your Needs
Every loan starts with a need. That need varies from borrower to borrower.
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Whatever your reasons are for needing to borrow money, know what they are and have a strong idea of how much money you’ll need to achieve your desired ends.
The better you understand your borrowing needs, the less prone you’ll be to over-borrowing which can steeply reduce the possibility of not paying back your loan.
2. Looking Into Your Credit Score
Before applying for a loan, it’s extremely helpful to know what your credit score looks like. Your credit score tells lenders how worthy of a borrower you are. The better your credit score is, the more lenders will want to do business with you and the better deals they’ll offer.
Finding out what your credit score is and how good or bad your score appears to lenders is simple!
There are a number of websites that will give you your credit score for free instantly. If you don’t feel comfortable signing up for those services, you also have the option of requesting your credit report via mail as is described by the FTC.
3. Understand The Cost Of Money
One of the most essential discoveries that borrowers make when trying to figure out how loans work is that borrowed money costs money. After all, banks aren’t in the business of helping people for free. They’re in the business of being profitable.
There are two chief ways that loans generate profits:
Interest is a percentage that is attached to your loan. It drives up the amount of money that you need to pay back to your lender.
For example, if you borrowed $100.00 at a 10% interest rate and you were asked to pay back your loan in one month, at the end of the month you’d pay your lender their $100.00 (the principal amount that you borrowed) plus 10% in interest ($10.00).
Where things get tricky is when you don’t pay your lender back in one month.
If you waited two months to pay back your lender their $100.00, interest would accrue on your account twice which means that you’d have to pay $121.00 ($100.00 x 10% = $110.00 x 10% = $121.00).
After interest, fees are the go-to way that lenders make money. Fees can be charged on a variety of things from paying off your loan too late, to paying it off too early.
Make sure that you’re vigilant as to which fees a lender charges before taking out money. Some lenders get tricky about the fees that they impose on borrowers in an effort to inflate their lending costs.
4. Apply For Loans
After you’ve done your initial “how loans work” research in figuring out what you need to borrow, your credit situation and how much money costs, it’s time to start actually applying for loans!
Loans can be found at your local bank, credit union and online. Wherever you find your loan, be sure to read its details carefully to make sure that you’re not overpaying in interest or fees.
Also, be honest with yourself about which loans you qualify for. If you have average credit and a loan product says that only people with good credit tend to have their applications accepted, don’t apply for that product since loan rejections can hamper your credit history.
5. Paying Back Your Loan
Once you’ve found a loan that approves you, you’ll receive your money and will be free to start spending. Per your loan’s terms, just make sure that you’re keeping up with payments.
Some loans are monthly payment loans that will want payback each month over a specified time period. Other loans are single-pay loans which will ask for one lump payment at the end of an allotted period.
6. The Aftermath Of Managing Or Mismanaging Your Loan
If you’ve taken out a loan from a reputable lender and meet all of your obligations to them, eventually, your loan will be paid off. Once it is, your credit score will go up and you’ll now qualify for better loan products in the future (lower interest, less fees, etc.).
If you haven’t managed your loan correctly, your balance will have swelled due to compound interest and fees, your credit score will have gone down and your debt may have even been transferred to collections. Collections departments are typically operated by third parties and may harass you until you settle your debt.
Wrapping Up How Loans Work
Understanding how loans work is key to ensuring that you borrow money responsibly. Loans are a powerful way to boost your situation.
But, if used in the wrong way they could get you into more of a mess than you started with.
Pay attention to the fine print on the loan paperwork.
Make sure you make your payments on time. Account for interest. All these steps will make the loan a positive experience instead of a thorn in the side. We hope that our article has helped to improve your comprehension of borrowed money.
We also welcome you to read more of our blog content if you’d like additional information!