When you borrow money in the form of a loan, you will need to pay back the loan amount plus interest within an amount of time. This repayment typically occurs over the life of your loan, whether that’s three years or 30 years.
Before you sign the agreement to get your new loan, it’s useful to understand exactly how your payment will be applied to your loan over time. Take a look.
How Does A Loan Work?
A loan is a commitment that you (the borrower) will receive money from a lender, and you will pay back the total borrowed, with added interest, over a defined time period. The terms of each loan are defined in a contract provided by the lender. Secured loans are loans where borrowers can put up an asset (like a house) as collateral. This gives the lender more confidence in the loan. Unsecured loans are loans approved without collateral, so the lender takes on more risk.
How Does Your Credit History Impact Your Interest Rate?
Before you can take out a loan, secured on unsecured, you first have to apply. Financial institutions and lenders will do a soft credit pull first to confirm you meet the minimum requirements to apply. If you move forward with an application, the lender will do a hard credit check to review your credit history.
If you want to review your own credit history you can request a credit report from one of the major credit agencies; Experian, Transunion, and Equifax. You can request a free report each year from each lender, so you can see what a lender will be reviewing.
Your creditworthiness will play a role in the interest rate offered. If you have a good credit score, the lender will have more peace of mind that you will repay your loan, and offer you a lower interest rate or maybe a larger amount of money. If you have a lower credit score you might want to build your score back up before submitting a loan application to see a better loan offer.
Read more: How to Build Credit in 6 Easy Steps
How Is Interest Calculated?
The interest rate is the proportion of a loan that borrower pays in addition to the principal due. Think of it as the fee you pay to the lender for using its money. As with types of loans, there are many different flavors of interest rates offered:
The most clear-cut, simple rates are just multiplied to the principal at each payment period to find the interest due. For example, if you borrow $2,000 from a family member and they ask for 5% interest when you repay them for the loan in a year, at the end of the repayment term you would owe them $2100.
Common for credit cards and savings accounts, compound rates charge interest on the principal and on previously earned interest. For example, if you borrow $2,000 at a rate of 5% over a year, you would owe $100 in interest in the first year. In the second year, you would owe $2,205, as you would calculate a 5% interest payment on $2,100 that year.
Amortized loans are designed so the borrower pays a larger amount of interest, rather than the principal, at the beginning of the loan. Over time the amount of principal in each payment will increase, widdling down the principal and amount of interest charged on the principal. While the payments due stay the same over the years, what the payment goes toward (principal vs. interest) shifts during the life of the loan. These are popular for car or home loans.
A fixed interest rate will be defined upfront and stay the same over the term of the loan. This makes budgeting for payments predictable.
Variable (or adjustable) rates change over the life of the loan to reflect changes in the market interest rate. This means that the interest rate for your loan could go down or up over the term of your loan.
How Does a Loan Payment Work?
Loans are paid in pre-defined increments over the term defined. Say you make monthly payments towards your car loan, each payment will cover the interest due and some amount of the principal. The more money you can apply to a payment means more principal you knock out in each payment. Paying down your principal and wrapping up a loan quickly means you can save money you would have spent on interest payments.
To learn more about features Earnest offers to clients repaying loans with us, please see ‘Repaying Student Loans with Earnest: 7 Amazing Things You Can Do as a Client‘.
How Do Payments Change Over The Life Of A Loan?
As the principal due on the loan gets smaller with each payment, less interest accrues. This means that over time you will see less and less of your monthly payment going to interest payments, and more to the principal still due. This is easiest to see in 15 or 30-year loans that shift gradually over a longer time period.
What Loan Products Does Earnest Offer?
Student Loan Refinancing: Student loan refinancing allows borrowers to adjust the interest rate of loans they took out to finance an education. This adjusted rate better reflects their current financial standing. This is a good choice for people who have seen advances in their income, career, or credit score since they were in school.
Private Student Loans: For students enrolled in school looking to take on a private loan to cover the cost of their education, look no further. We built a clean and simple application that educates borrowers and cosigners as they take this step together.