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A loan is money, property or other material goods given to another party in exchange for future repayment of the loan value amount, along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as an open-ended line of credit up to a specified limit or ceiling amount.
How a Loan Works
The terms of a loan are agreed to by each party in the transaction before any money or property changes hands. If the lender requires collateral, this requirement will be outlined in the loan documents. Most loans also have provisions regarding the maximum amount of interest, as well as other covenants such as the length of time before repayment is required.
Types of Loans
A number of different factors can differentiate loans and affect their costs and terms.
Secured vs. Unsecured Loan
Loans can be secured or unsecured. Mortgages and car loans are secured loans, as they are both backed or secured by collateral.
Loans such as credit cards and signature loans are unsecured or not backed by collateral. Unsecured loans typically have higher interest rates than secured loans, as they are riskier for the lender. With a secured loan, the lender can repossess the collateral in the case of default. However, interest rates vary wildly depending on multiple factors.
Revolving vs. Term
Loans can also be described as revolving or term. Revolving refers to a loan that can be spent, repaid and spent again, while term refers to a loan paid off in equal monthly installments over a set period (the ‘term’). A credit card is an unsecured, revolving loan, while a home-equity line of credit (HELOC) is a secured, revolving loan. In contrast, a car loan is a secured, term loan, and a signature loan is an unsecured, term loan.
Special Considerations for Loans
Interest rates have a huge effect on loans: Loans with high interest rates have higher monthly payments – or take longer to pay off – than loans with low interest rates. For example, if a person borrows $5,000 on an installment or term loan with a 4.5% interest rate, they face a monthly payment of $93.22 for the next five years. In contrast, if the interest rate is 9%, the payments climb to $103.79.
[Important: Loans with high interest rates have higher monthly payments – or take longer to pay off – than loans with low interest rates.]