As a borrower, it‘s important to understand some of the key loan terminology used by lenders. Knowing these terms can help you better understand the products you’re looking at, giving you the ability to choose the right loan for your needs, and potentially avoid costly mistakes. In this article, we’re going to break down seven common loan terms that you’ll likely come across as you look to learn more about personal loans.
1. Annual Percentage Rate (APR)
Annual Percentage Rate (APR) is the total cost of a loan expressed as an annual percentage. APR is a key factor in determining the cost of a loan and should be carefully considered when evaluating your potential loan options.
APR is calculated by taking the interest rate on a particular loan and adding any additional fees or charges associated with the loan. This can include application fees, closing costs, and other charges. The resulting number is the total cost of borrowing on an annual basis.
It's important to note that the APR of a loan is not the same as the interest rate. The interest rate is simply the rate at which the lender charges you to borrow money. The APR, on the other hand, takes into account all of the other costs associated with the loan. As a result, the APR is typically higher than the interest rate.
One of the advantages of using the APR to compare loan options is that it provides a standardized way to evaluate different loans. Since the APR takes into account all of the fees and charges associated with the loan, it can give you a more accurate picture of the total cost of borrowing. By comparing the APRs of different loans, you can get a better idea of which loan will be the most cost-effective for your needs.
It's important to note that the APR is not the only factor to consider when evaluating potential loan options. You should also consider the loan term, repayment schedule, and any other terms and conditions associated with the loan. When evaluating loan options, it's important to look at the total cost of borrowing, including both the interest rate and any fees or charges, to make an informed decision.
2. Amortization
Amortization is the process of paying off a loan through regular payments over a set period of time. The payments are typically divided into equal amounts, with a portion going towards the principal amount and the remainder towards interest. As the loan balance decreases, the interest portion of the payment also decreases, and the principal contribution increases.
3. Collateral
Collateral is any asset that a borrower pledges as security for a loan. It can be any item that has value and can be seized by the lender in case the borrower defaults on the loan.
The most common forms of collateral are real estate (e.g. homes), cars, and other personal property (e.g. jewelry, electronics). When you apply for a loan, the lender will evaluate the collateral you’re offering to determine its value. The lender will also consider the condition of the asset, its liquidity (how easily it can be sold), and the current market value.
Overall, collateral is an important part of the loan process, and it's essential to understand what it is and how it works. If you’re considering pledging collateral for a loan, it's important to carefully evaluate the risk and to make sure you can meet the loan terms and make your payments on time.
4. Debt-to-Income Ratio (DTI)
Debt-to-Income Ratio (DTI) is a key factor that lenders use to determine a borrower's creditworthiness. It’s the ratio of your monthly debt payments to your gross monthly income. The formula for calculating DTI is simple: add up all of your monthly debt payments (such as credit card payments, student loan payments, car loan payments, and other debts), and divide the total by your gross monthly income.
For example, if your monthly debt payments total $1,500 and your gross monthly income is $4,500, your DTI is 33%. In general, lenders prefer borrowers with a DTI of 36% or less. A higher DTI indicates that you’re carrying a lot of debt relative to your income, and you may not have enough income to cover additional debt.
This means that having a high DTI can make it harder to qualify for a loan, as lenders may be concerned that you’ll struggle to make your loan payments, and they may view you as a higher credit risk.
If you’re planning to apply for a personal loan, it's a good idea to calculate your DTI beforehand to get an idea of where you stand. You can use an online DTI calculator to help you figure out your debt-to-income ratio.
If your DTI is too high, there are a few things you can do to improve it. You can try to pay down your debts, increase your income, or both. This may mean taking on a side job, negotiating a raise at work, or finding ways to cut back on your expenses. Improving your DTI may not only impact your chances of qualifying for a loan, but it may also help you to avoid falling into too much debt.
5. Prepayment Penalty
A prepayment penalty is a fee charged by the lender if you pay off a loan before the end of the loan term. This fee is designed to compensate the lender for the loss of interest that would have been earned if the loan was paid off over the longer or full term. Prepayment penalties can be a significant expense, especially for borrowers who plan to pay off their loan early. Before taking out a loan, it’s essential to read the terms and conditions carefully to determine if there is a prepayment penalty and if it would be worth paying in certain circumstances.
6. Secured Loan
A secured loan is a type of loan that’s backed by collateral, like a car or a home. If you aren’t able to make your loan payments, the lender may seize your asset in lieu of payment.
Secured loans can be used for a variety of purposes, such as purchasing a car or home or making home improvements. Some common types of secured loans include car loans, mortgages, and home equity loans.
It's important to note that using collateral also means that you risk losing your asset if you cannot make your loan payments. This is an important consideration when deciding whether to apply for a secured loan. You should carefully evaluate the risk and make sure you can meet the loan terms and make your payments on time.
7. Unsecured Loan
An unsecured loan is a loan that does not require collateral to be pledged as security for the loan. In some cases, these loans may have higher interest rates than secured loans because the lender has increased risk. Examples of unsecured loans include personal loans and credit card.
Improve your Financial Literacy
Sifting through loan terminology can make your eyes hurt if you’re not familiar with what you’re looking at. Having said that, understanding loan terms is crucial when applying for a loan. A clear understanding of how a loan works and what you’d be getting yourself into can help you choose the right loan for your needs and avoid costly mistakes. Make sure to stay educated, and don’t accept a loan offer if you’re not clear on what you’re agreeing to. The seven loan terms we’ve discussed above are essential for borrowers to know, and we hope this article has been helpful in explaining what they mean.
Disclaimer: This article provides general information only and does not constitute financial, legal, or other professional advice. For full details, see CreditFresh’s Terms of Use.
