Loans & Borrowing: 10 Terms You Should Know
Whether you’re managing your day-to-day finances or preparing for the future, loans and credit cards may be an important financial tool to support your personal goals.
The process of comparing your financing options and choosing the right one can sometimes feel overwhelming – especially with all the financial jargon and concepts associated with loans and borrowing. Fortunately, many of these concepts are less complicated than they seem. Here’s a quick overview of some of the most important borrowing terms you should know. Learn them now, so you can make smarter borrowing decisions later.
10 Essential Borrowing Terms
This is the process of repaying a loan in installments according to a predetermined schedule. For example, a five-year auto loan spreads out your payments over five years, and a 30-year mortgage is divided into 30 years of monthly payments. To ensure that a potential loan will fit your budget, it’s important to find out what your monthly principal and interest payment will be, based on the amortization schedule.
Annual Percentage Rate (APR)
APR is your yearly cost of borrowing, expressed as a percentage of your loan. The lower the APR, the lower the cost. The calculation of a loan’s APR may also include certain fees, making it a more accurate representation of your total cost of borrowing than the interest rate alone. Comparing APRs is useful when shopping for a mortgage, auto loan, credit card, or other financing product.
Your credit score is a representation of your creditworthiness, using a number ranging from 300 to 850 (the higher, the better). The FICO® Score is the most common type. A credit score may be assigned to you by each of the three main credit rating agencies (Experian, Equifax, and TransUnion), based on the contents of your credit report, which is a compilation of past borrowing activity reported by lenders.
Factors that influence your credit score include your history of on-time loan payments, credit utilization (the amount you borrow compared to your available credit limit), and the length of your credit history. Financial institutions and other lenders use your credit score to determine if you qualify for a loan and what your interest rate will be.
Debt-to-Income Ratio (DTI)
Lenders want to make sure that you have the means to pay them back. That’s why they often look at your debt-to-income ratio, which compares your monthly expenses to your monthly income. The lower your DTI, the easier it is to afford a new monthly loan or credit card payment.
A default occurs when you are unable to keep up with payments for a loan. When that happens, you risk losing your collateral (for a secured loan) or having wages garnished to pay back what is owed. Additionally, loan defaults can seriously damage your credit.
Because defaulting on a loan can have long-term financial consequences, it’s important to carefully review the terms of any loan or credit card before accepting it. Make sure you feel confident that you can afford to make the monthly payments.
This is the upfront payment borrowers may be required to make to finance the purchase of a big-ticket item like a home or car. Your ability to pay a portion of the purchase price out of pocket helps assure the lender that you are a serious borrower who is financially committed to the purchase. Down payments can be as low as 0% or as high as 20% or more (such as for a home). A larger down payment may help you secure a lower interest rate.
The interest rate is your cost of borrowing. Your interest will be determined by the lender based on current market rates and an assessment of your creditworthiness. Depending on the type of loan, your interest rate may be:
- Fixed: The interest rate is locked in for the life of the loan. This is common with long-term loans like mortgages, and it helps you avoid having your loan payments go up due to rising rates.
- Adjustable: This option is available for mortgage borrowers. With an adjustable-rate mortgage, your interest may be fixed for a period of time, such as a few years, before resetting periodically based on current market rates. Some borrowers choose an adjustable-rate mortgage to pay less early on.
- Variable: Your interest changes over the life of the loan based on current interest rates. This is common with credit cards.
This is the process of paying off the balance of a loan with a new loan that offers a different rate or other terms. It can be a valuable way to save money on interest, lower your monthly payment, or pay off a debt sooner.
With this type of financing, a lender sets your credit limit and gives you the flexibility to borrow more than once, for as much as your credit limit allows. You can access additional funds by repaying what you’ve already borrowed, and you only have to pay interest on the amount you borrow. Common forms of revolving credit are credit cards and home equity lines of credit (HELOCs).
A secured loan uses collateral to help you qualify for a loan with a lower interest rate. When you take out a secured loan, such as a mortgage or auto loan, the lender has the right to take possession of the collateral if you fail to repay your loan. Secured loans usually offer more affordable interest rates because they present less of a financial risk for lenders than unsecured loans, which are supported only by the borrower’s creditworthiness. Unsecured loans include most credit cards, many personal loans, and student loans.