When you go to get a loan, especially if you are new to borrowing or are taking out a new kind of loan, the loan terms and conditions can be a bit overwhelming. There is a lot of fine print, and while recent laws have forced lenders to be clearer about some things, it is still a good idea to be a savvy borrower.
Here are some loan terms and conditions that you should understand before you sign the contract for any loan. If you do, borrowing may cost you way less, and you will be much more aware of the cost of going into debt.
4 Things You Must Know About Loan Terms & Conditions
1. The Term of a Loan
The term of the loan is how long you will be borrowing the money for. On a car this is often a five or six-year (60 or 72 month) loan. On a home mortgage, this might be a fifteen or thirty-year loan. While on a personal loan, this is often a 12 or 18-month loan period.
The length of the loan often depends on what the loan is for, if it is secured or unsecured, your credit score, income, and what kind of payments you can afford.
Small business loans can vary in term as well, and for similar reasons. There are even more variances in the terms of these loans all depending on who is issuing the loan and what for.
The primary point here is that the term of the loan can vary a great deal, but when boiled down to its essence is how long you have to pay back the loan.
2. Are You Interested?
The other term that is often misunderstood when it comes to loans is the annual percentage rate and compounded interest. The annual percentage rate is easier to see and understand. This is simply the interest rate that you will pay every year on the amount of the loan, or the principal. The principal is the amount you owe if you were to pay off the loan today.
Compounded interest is a little more complex. Essentially the principal is the amount of money you initially borrowed. The current value of the loan is expressed in a formula that includes the interest that is added to the principal depending on how often the interest is compounded.
For example, let’s say you take out a $5,000 loan for 10 years at a great annual interest rate of 5%. The interest is compounded monthly. At the end of the 10 years, you will have paid $8,235.05, if you make all of your payments on time and don’t make any extra ones or pay it off early.
This is because interest is added to the principal every month, and you also pay interest on that amount the next month, and so on. The more often the interest is compounded and the higher the interest rate the more you will pay for the loan in the long run.
3. Secured vs. Unsecured
There are also two different types of loans: secured and unsecured. Let’s look at the simplest type first, the unsecured loan.
An unsecured loan is granted to you based on your income, your credit score, and the debt you already have, or your debt to income ratio. It is secured simply by your signature, essentially your promise on a contract to repay the loan. These types of loans are usually issued by your bank or another institution and are short term.
A secured loan is like your car loan or your home mortgage. The amount of the loan is secured by an asset that has value on its own. You can get a secured loan against your 401k or investments, but the most common involve real property. The term on these loans varies, depending on what you are financing. As already mentioned above, for cars this is often five or six years, and for a home the term is much longer.
The credit requirements for these loans are usually not as strict as for an unsecured loan because you have something to backup your promise. That something is known as collateral. They are still tied to your credit score though, and if you have a poor credit score you will often face a higher interest rate or the lender will require a higher down payment or both.
While there are several different names for different types of loans, most of them fall into one of these two categories. The exception is a partially secured loan in which part of the loan is secured by an asset, and the rest is simply a contract.
4. Total Cost of the Loan
When we mentioned compound interest above, we also mentioned the total cost of the loan. We used the example of a personal loan with a very low interest rate, but a relatively long term for that type of loan.
However, if you look at car loans or mortgages, two of the most common types of debt, you will note that with compounded interest, you will pay much more than the value of the vehicle or the home by the end of the loan if you don’t pay it off more quickly. For example, if you make double payments on your home, you will pay it off in about a third of the term of the loan because of the interest you will save. The same is true for your car.
As an example, we will use a 30-year mortgage on a $300,000 home. If you put a 20% down payment of $60,000, your original loan amount is $240,000 dollars. However, the sum of 360 payments of $1,207.50 (your mortgage payment) is $434,701.29. The interest you paid is a total of $194,701.29. If you pay the loan off in half that time, you will only pay $329,153.94 total and $89,153.94 in interest.
The longer your financing is for, and the more often the interest is compounded, the more the total cost of the loan will be. Paying loans off faster or early will save you thousands of dollars in many cases.
It is important to understand the loan terms and conditions and what a loan will actually cost you in the long run. The better you understand the borrowing process, the more money you will save, the better you can negotiate terms for any loan you choose to take out.