Loans: Definition, Types, Loan consolidation

A loan is a sum of money borrowed from a lender or creditor that must be paid back in full with interest at a later date

Loans can be a good way to get extra cash to meet urgent needs, expand a business, get an education, or buy a house. For whatever reasons loans can be quite resourceful for people who need them. However, before taking a loan it is best to carefully read through the terms and agree to them before proceeding.

What is a Loan?

A loan is a type of credit vehicle in which a lender or creditor lends an amount of money to the borrower in exchange for future repayment of the principal amount. Interests or finance charges are also added to the principal amount, to which both parties involved must agree upon. Agreement in a loan deal is very crucial, that way both parties will know what they are getting into.

Loans can be obtained from financial institutions like banks, online lenders or credit unions; or individual lenders like family and friends. The most common loan for American households is the mortgage.

Features of a Loan

A loan basically has four features. Understand these features will help you determine the type of loan you want and if it is affordable to suit your purpose.

Principal: This is the initial amount involved. It is the money the borrower receives from the lender. There are no fixed principals, only that which is agreed upon by the parties involved. It could be $500 to get a new computer or $100,000 to expand a business.

Interest: This is the cost of the principal [loan], that is, the extra amount you will have to pay in addition to the loan. Loan interest rates are determined by the lenders and they could be based on your credit score, the loan type, the amount involved, and your how long you will need to pay back the loan.

Note: Interest rate greatly differs from the annual percentage rate (APR), which consists of other costs like upfront fees.

Term: A loan term simply means the duration of time you have to pay back a loan. Loan terms range from a few weeks/months to a couple of years depending on the type of loan.

Installment payments: Loan payments can either be made one time or installments depending on the amount of time you have to repay the loan. Installment payments include a fixed time and a fixed amount that will be credited to the creditors' account.

Types of Loans

There are majorly two types of loans: secured and unsecured

• Secured loans: This type of loan requires the borrower to provide some sort of collateral that can be held by the lender if any failure to repay the loan occurs. Basically, before getting a loan, you would be required to use a physical asset with a value equivalent to the amount of loan as collateral such as valuable personal property, stocks, or bonds. You will also be required to present a title deed or any other documents that show ownership of an asset before it can be accepted as collateral. The lender uses the collateral to secure its money in case you cannot pay back as agreed since large amounts of money are involved. The interest rate of a secured loan is usually based on your credit history and credit score, and they are usually lower than unsecured loans. Examples: a mortgage, an auto loan.

• Unsecured loans: No collateral is required to take this type of loan. Lenders grant such loans based on your credit score and credit history. It is unsecured because the lenders do not require any physical assets to secure their money. However, in the event of failure to pay back a loan, lenders can report defaulters to the credit bureaus which will badly affect their credit score and prevent them from getting another loan in the future. Depending on the circumstances involved, lenders can file legal cases against the defaulters as well as report them to credit bureaus. Unsecured loans also come at smaller amounts with higher interest rates as opposed to secured loans. Examples: personal loan, payday loan, student loan.

Other types of loans:

• Open-End and Closed-End Loans: In an open-end loan, you have the liberty to borrow different amounts of money at different times. Credit card loans and line of credits fall under this category of loans. An individual may have access to the money available in his credit card at any time with a credit limit in place. A credit limit refers to the highest amount of money the borrower can withdraw at any given time. A person with a credit card can decide to either withdraw all the money on the credit card or take out a portion of it. Either way, it is very much a loan and must be repaid at the stipulated time. While closed-end loans include regular loans such as a mortgage, auto loans, students’ loans, etc. A borrower cannot get access to extra money unless the previous loan has been repaid.

• Conventional loans: This term is mostly used when applying for a non-government insured mortgage. That is a loan that is not insured by official agencies such as the Rural Housing Service (RHS).

Personal Loans

A personal loan is money borrowed from any lending institution or platform such as banks, online lenders or credit union, to meet urgent personal needs such as buying a car, paying for a wedding, or remodeling a house. Repayments are done in installments or fixed monthly payments over a duration of a few weeks/months to about five years, depending on the lender.

Most personal loans are ‘unsecured’ only in very few cases. Basically, you don’t need any form of collateral to obtain a personal loan, only your credit history, credit score, and debt-to-income ratio. The interest rates on personal loans are relatively cheap compared to credit cards. Although, the limits to how much you can borrow with a personal loan are usually higher.

Payday Loan

A payday loan is a type of short-term loan granted to a borrower by a lender for meeting urgent needs. As the name implies, the borrower must repay the loan by the next payday. The amount or principal granted in a payday loan is equivalent to a portion or a percentage of the borrower’s next paycheck. They are typically based on the income or earnings of a borrower. Therefore, the borrower must provide a paystub when applying for the loan. While these loans are easier to secure, they charge high-interest rates for short-term credits. They are also known as cash advance loans or check advance loans.

Payday loans are unsecured loans that do not require borrowers to provide any collateral. These loans have a reputation to have ridiculously high interest rates and other hidden fees/charges.

Student Loans

A student loan is designed to provide students with affordable loans in order to pay school-related fees like tuition, books, school supplies, and living expenses. These loans are mostly offered to college students at very low-interest rates and a grace period is given to them—until graduation.

There are different types of student loans. Some are federal government funded while the others are private. The advantage of federal government funded student loans is that it offers borrower protection and lower interest rates. This makes federally-funded student loans more appealing than those offered by private institutions or commercial lending institutions. Federal loans also offer interest deferment programs, whereby, the federal government covers the loan’s interest while the student is still in school. Students will only be obligated to start paying back the loan after graduation.

Commercial lending institutions also give student loans, however, they require a full underwriting process. Borrowers are also required to have a positive credit score and a good income flow to make loan payments. Private loans come with higher interest rates and may be due within a shorter period of time compared to federal loans.

Loan Consolidation

Loan consolidation is a process that allows a student to consolidate multiple student loans into a single loan such that payments can be made only once each month. It also allows students to extend the repayment term. Both federal and private lenders offer student loan consolidation, although, private lenders tend to charge a fee for their consolidation services.

The primary purpose of creating the loan consolidation is to enable students to easily manage all their loans in a single loan. There are tendencies that students must reapply for student loans every year, therefore, have multiple student loans upon graduation. This can make managing all the loans tiring and confusing. Hence, the need for loan consolidation.

Merging or consolidating multiple loans into one will create a new loan that will have a fixed interest rate. A fixed interest rate is preferable due to their stability and predictability; especially if you have variable interest rates. However, if your existing loans come with some benefits such as interest rate reductions or rebates, a loan consolidation would hinder such benefits.

Nevertheless, loan consolidation is a good way to make student loans more affordable with an extendable loan term of 30 years. While payment will be decreased, interest rates will be increased – you will pay more interest expenses. Loan consolidation repayment plans are classified into three: standard, graduated, and income-based.

The standard repayment plan is a fixed payment for up to 30 years. The graduated repayment plan refers to an increase in payment over time. The income-based repayment plan is based on the borrower’s income.

Advantages of Loan Consolidation

• It simplifies loan repayment or bill paying. Instead of making multiple monthly payments to different lenders, you can conveniently make a single payment to a single lender.

• By extending your loan term, you can pay lower amounts monthly. For example, if you were to repay $100 each month for a $1,200 principal, over the course of 12 months. You can extend the loan term to 2 years and pay $50 each month. That way you can save up money for other things.

• You have the convenience of managing only one loan at a time, rather than managing multiple loans simultaneously.

• Interest rate reductions are offered by some lenders when you make automatic repayments from a savings or checking account.

• Some lenders provide the option of both managing and repaying your loan online.

Disadvantages of Loan Consolidation

• Increased interest rate expenses. You get to pay more on the original loan over a longer period of time compared to paying as soon as possible.

• Your new loan may hinder other benefits that come with your existing loans such as interest rate reduction. You may lose eligibility for certain benefits that were linked to the previous loans.

• The consolidation process cannot be reversed, and original loans must be paid in full without the option of reinstating them.

Federal Student Loan Consolidation

• You must have at least one eligible federal loan either through the Direct Loan Program or Federal Family Education Loan Program.

• Interest rates of loans in this category will be based on the weighted average of the interest rates of the loans you are consolidating. It will be rounded to the nearest one-eighth of one percent, not exceeding 8.25. This is a fixed rate and should not be expected to change over the duration of the loan.

• Any consolidation don through the Federal Direct Loan Program will make you eligible for a service loan-forgiveness program.

• Visit www.loanconsolidation.ed.gov. for more information about the Federal Loan Consolidation Program.

The only types of federal student loans that can be consolidated are:

• Direct Loans

• Federal Stafford Loans

• FFEL PLUS Loans

• Direct PLUS Loans

• Health Education Assistance Loans

• Federal Nursing Student Loans

• Federal Perkins Loans

Note: Private loans and Parent PLUS loans cannot be consolidated.

Private Student Loan Consolidation

• If you have one or more private student loans, you can consolidate with a private consolidation loan through a private lender. Many private lenders offer variable interest rates based on the applicant’s credit. That means the interest rate is bound to increase or decrease over the loan term.

• To get a private loan consolidation, you may need a cosigner to a portion of the loan term, since private loan consolidation are based on credit.

• Some private lenders offer joint consolidation for spouses that both have private student loans.