So you’ve been saving money for the last month, but that PS5 is still way out of reach. If you’ve been diligent about setting money aside, maybe you’re ready to take your financial education to the next level and learn about loans.
Sounds complicated? Something only grown-ups do? Fear not! It’s never too early to learn the basics of finance. Plus, you might be surprised to learn that you too could get a loan too – and get closer to that PS5!
What Is a Loan?
Simply put, a loan is money someone gives you and you promise to pay back after some time, with a little extra added. That someone is typically a financial institution, like a bank. But it can also be a family member, like your parents or grandparents.
So, for example, you want that new video game about a war deity that all the influencers are raving about. That’ll cost you an out-of-reach $59! Your parents already said you could have it, but you have to wait for your birthday, which is ten months from now. No way you can wait that long!
Want to get your hands on that game sooner? One option is to ask your parents for a loan. This means they’ll give you the money now, and you have to pay them back the $59, plus a bit more for their trouble. But you don’t have to pay it all back at once. You can pay them over time.
Banks work the same way. Grown-ups take out loans to buy houses and cars or to pay for other expenses, like medical bills or weddings. The only difference is that grown-ups usually borrow money from a bank instead of their parents.
How Do Loans Work?
A loan is an amount of money you wouldn’t be able to access any other way. When you get a loan, you agree to do several things:
- You agree to pay back the money in full (this is also known as the principal)
- You agree to pay a little extra (aka, the interest)
- You agree to pay in equally spaced installments (typically every month), for a number of months (this is called the term of the loan)
Let’s look at an example. Let’s suppose you want something out of reach, like that new PS5 (it might also be out of stock, but that’s a different problem!). Imagine, for the purpose of this example, that you already have a running pet-sitting business and you are making $100 a month.
You ask your parents for a loan of $500, and you promise to pay $52 every month. That’s about half of what you make. You also agree to pay this amount for ten months.
At the end of the term (the ten months), you will have achieved many great things: For starters, you will have that super cool PS5 way sooner than if you’d saved for it or waited for your birthday.
But, believe it or not, there are more benefits to borrowing money from your parents. You’ll learn about loans and how they work for you, and in the process, you will show your parents that you are financially responsible. So, as long as you pay the loan back, it’s a win-win-win situation!
What Are the Different Types of Loans?
There are two main kinds of loans. In the world of banking, these are known as secured and unsecured loans. The main difference between them is that, for secured loans, the lender sometimes asks for something to keep in case you can’t pay. When the lender doesn’t ask to keep something, it’s called an unsecured loan.
Now, let’s explore the different types of secured and unsecured loans in more detail. Many of these might be out of reach for you now (Wait, what? You already wanna buy a house?!), but it’s never too early to learn the differences between loans for when the right time comes, and you’re ready to make a big purchase.
Typically used for personal expenses or unforeseen circumstances, personal loans are:
- Usually unsecured loans
- Offered by banks, but could also be provided by family or friends
- The amount borrowed tends to be on the smaller side
- The interest rate will depend on the borrower’s financial standing and credit history. The better your financial situation is, the lower the interest rate you’ll have to pay
This refers to a loan taken out with the specific purpose of buying a house. Other deets to know:
- This is a secured loan, offered by banks
- The house itself acts as the “collateral,” meaning it will belong to the lender in case the loan is not paid off
- The rates for these loans are often much lower than that of a credit card
You guessed it! This is a loan that you use to buy a car, a truck, or a motorcycle. Some important info about auto loans:
- Car dealerships and banks offer this kind of loan
- They usually have higher interest rates than a home loan
- It’s a good idea to pay this kind of loan off as fast as possible to pay less money in interest
Credit Card Loans
Credit cards are their own thing, but sometimes you can think of them as a type of loan. You’ve probably seen your parents use credit cards. Because these are loans you can pay off (and you should!) and use them over and over, they’re also known as revolving credit.
- Interest rates will depend on your credit history, but tend to be high
- You should aim to pay it off in full every month because you pay zero interest, and it looks good on your credit history!
- Credit limit amounts can vary depending on your credit score
Pros & Cons of Loans
Loans are an advanced instrument in your financial toolbox. You need to be financially responsible to use them. What does this mean? In plain English, it means that you need to have a way of making money so you can pay on time.
Loans are really not difficult once you get the hang of ‘em, and they can be a great way to make debt work for you. Here are some of the pros and cons of loans:
Pros of Loans
Loans can help you enjoy things sooner or pay for unexpected expenses. This could be buying your PS5, a car, or paying for a health emergency. The benefits of this include:
- Get money sooner than it would take you to save it
- Learn about how debt works
- Become more responsible with money
Cons of Loans
If you’re not prepared, loans can be a bit too much because you need to constantly generate money to make the monthly payments. Some of the negatives of taking out loans could include the following:
- You have less money to spend every month (because you use some to pay the loan)
- You can’t stop working (but hey, who wants to stop!)
- If you can’t pay it back, it will be hard to get another loan
How Your Parents Can Help You Learn More About Loans
If you’re curious about loans, asking your parents is a great way to start. They’re a trusty resource to guide you in your quest! Even when adults don’t know everything, they’ll have fun exploring and learning together with you.
If you’re an entrepreneurial kiddo who’s thinking about starting your own car wash or online jewelry store, you’ll need money to get you started. Without cash, how will you buy soap and sponges or beads and charms?
The good news is that parents can help you out. If they see that you’re motivated and knowledgeable (after all, you read this blog post!), they are more likely to agree to loan you that starting money. Once you have your business up and running, you can repay the loan, and then the sky’s the limit.
If you’re not sure how to ask, here’s one way to increase your chances of getting a loan from your parents:
- Generate income or use your initial loan to start up a business. Car washing, pet sitting, online jewelry, or even doing extra chores at home are great ways to make extra cash. By proving that you have money coming in, the lender (in this case, your parents or grandparents) can trust that you’ll pay them back.
- Agree on the conditions of the loan. Talk to your parents about the principal, the interest, and the term, so you’re all on the same page.
- Pay on time. It’s important to have reasonable expectations of how much money you can earn. And remember to save some of that income for ice cream, comics, and other things you might want. As a rule of thumb, if you make $20 a week, don’t expect to pay more than $10 a week towards your loan.
Important Loan Definitions
A solid financial education starts with the right vocab. Here are some important words that you should know if you want to learn more about loans:
- Principal: The amount of money you get from the lender (bank or parent).
- Interest: The amount of extra money you pay back to the lender.
- Lender: The one giving you the money (typically a bank, but it can be a family member, like your parents, or your grandparents).
- Debt: What you owe the lender; simply, the principal plus interest.
- Interest Rate: A percentage of the principal you pay in addition to the amount you borrow.
- Term: How and when do you plan to pay back? For example, you can agree to pay back in monthly installments for six months, two years, or in any amount of time that you mutually agree on.
Books & Other Resources to Learn About Loans
Ready to learn more about loans? You’re in luck! There are many books and websites that teach you about loans, and how to use loans that can help you financially. Here are some of our go-to’s:
Charlie’s Money Choices is the story of a kid who faces similar financial scenarios as you. As you read about how Charlie’s choices affect him and his finances, you can learn by example!
If games are more your thing, check out The Game of Life. In this classic board game, you and your family can learn how financial decisions such as saving, going to college, marriage, and getting loans will determine your future. Perfect for your next game night!
Finally, if you’re ready to learn about loans in a larger context, you’ll want to check out “All About Money.” This is a book that will cover much more than loans. In fact, it covers all the basics of how money works. Definitely a must-have for the money-savvy kid!
Ready to Borrow Responsibly?
Loans are an important part of your financial education and, when taken out responsibly and paid back with care, they can significantly expand your financial toolbox. From getting a new bike to buying your first house, loans can be a real financial game-changer.
Whatever you decide to do, knowledge is the first step to responsible borrowing and staying on top of your finances. Good luck and, as always, keep reading our blog to stay in the know!