Find out what loan terminologies you must know in order to understand what loan type works best for you!
Whether you’re applying for a personal loan, mortgage, or any other type of credit, there are some loan terminologies that you must know in order to make informed decisions, avoid misunderstandings, and ultimately save money.
When you take out a loan, you’re entering into a legally binding agreement with a lender. The terms of this agreement will dictate how much you pay, when you pay it, and what happens if you can’t pay it back.
So, as you consider your next loan, keep the terms we are going to show you in mind before signing on the dotted line. Also, if you want to check out more financial tips on our website, you can click on this link!
Loan Terminologies You Must Know
Principal
It is the initial amount of money that you borrow from the lender. It’s the base figure on which interest is calculated. For example, if you take out a loan of $10,000, that $10,000 is your principal. As you repay the loan, the principal decreases, and so does the amount of interest you pay.
Interest Rate
It is the cost of borrowing money, expressed as a percentage of the principal. There are two types of interest rates: fixed and variable. A fixed interest rate remains the same throughout the life of the loan, while a variable interest rate can fluctuate based on market conditions. Understanding the type of interest rate associated with your loan is crucial because it affects your monthly payments and the total amount you will repay over time.
Annual Percentage Rate (APR)
It is a broader measure of the cost of borrowing, which includes the interest rate and other fees associated with the loan. The APR gives you a more accurate picture of how much the loan will cost you annually. For instance, if a loan has an interest rate of 5% but the APR is 6%, the extra 1% represents additional fees. Always compare APRs when shopping for loans, as it provides a more comprehensive understanding of the loan’s cost.
Amortization
It refers to the process of gradually paying off a loan through regular payments over time. Each payment is divided into two parts: one portion goes towards reducing the principal, and the other goes towards paying the interest. In the early stages of a loan, a larger portion of your payments will go towards interest, but as the loan progresses, more of your payment will go towards reducing the principal.
Collateral
It is an asset that a borrower offers to a lender as security for a loan. If the borrower defaults on the loan, the lender has the right to seize the collateral to recover the money owed. Common examples of collateral include homes, cars, and savings accounts. Loans that require collateral are known as secured loans, while those that don’t are called unsecured loans.
Default
It occurs when a borrower fails to make the required payments on a loan. This can have serious consequences, including damage to your credit score, increased interest rates, and legal action from the lender. It’s important to understand the terms of your loan agreement to avoid default and the potential financial repercussions.
Credit Score
Your credit score is a numerical representation of your creditworthiness, based on your credit history. Lenders use credit scores to determine the likelihood that you’ll repay a loan. A higher credit score usually means you’re more likely to be approved for a loan with favorable terms, while a lower score may result in higher interest rates or loan denial.
Debt-to-Income Ratio (DTI)
It is a measure of your monthly debt payments compared to your monthly income. Lenders use the DTI ratio to assess your ability to manage monthly payments and repay debts. A lower DTI ratio is favorable, as it indicates that you have a healthy balance between debt and income, making you a less risky borrower.
Loan Term
It is the amount of time you have to repay the loan. It can range from a few months to several years, depending on the type of loan. A longer loan term generally means lower monthly payments, but you’ll pay more in interest over the life of the loan. Conversely, a shorter loan term means higher monthly payments but less interest overall.
Prepayment Penalty
Some loans include a prepayment penalty, which is a fee charged if you pay off your loan early. Lenders impose this penalty to recoup some of the interest they would have earned if the loan had remained outstanding for its full term. Before taking out a loan, it’s important to check if there is a prepayment penalty, especially if you plan to pay off the loan ahead of schedule.
Origination Fee
It is a one-time charge by the lender for processing a new loan application. This fee is usually a percentage of the loan amount and is either paid upfront or rolled into the loan balance. The origination fee covers the lender’s costs of underwriting and processing the loan, and it can vary depending on the type of loan and the lender.
Co-signer
This is how we call someone who agrees to take responsibility for a loan if the primary borrower fails to make payments. Having a co-signer can help you qualify for a loan if your credit score or income isn’t sufficient on its own. However, the co-signer is equally liable for the debt, which means their credit could be affected if you default on the loan.
Other Loan Terminologies You Must Know
- Balloon Payment: a large payment due at the end of a loan term, usually in loans with lower monthly payments;
- Grace Period: the time after a payment is due during which no late fees are charged, and the payment is not considered in default;
- Underwriting: the process by which a lender assesses the risk of lending to a borrower, including reviewing credit history, income, and other financial factors;
- Refinancing: the process of replacing an existing loan with a new one, typically to get a lower interest rate or change the loan term.