Learning about loans and how they work is a great way to start building a solid financial foundation for the future! Maybe you’ve heard your parents or other adults in your life talk about using loans for leverage or to cover emergencies that savings won’t cover, and you’ve wondered what all of it means.
We will discuss the ins and outs of what loans are, how they work, what they can be used for, and how to ask parents questions about loans!
What Is a Loan?
A financial loan is money that is borrowed from either a person or business to cover a specific purpose. You promise to pay the money back in full by a certain time and pay extra money as interest.
The interest rate you pay for the loan is determined by your credit score, payment history on previous loans, current income, and other debt on which you are making payments.
How Do Loans Work?
A secured loan will use something of value (called collateral) against the loan amount the lender can take as payment for the loan if you miss payments.
An unsecured loan does not use collateral but will have a higher interest rate than secured loans because they are riskier for lenders.
A term loan (also known as an installment loan) allows borrowers to repay the loan in fixed payments over a set period of time.
Fixed rate loans will offer borrowers a set interest rate throughout the entire loan that doesn’t change.
Variable rate loans will change with the prime rate, so if the prime rate goes up, your interest rate will go up.
Different Types of Loans
According to Experian.com, there are eight different types of loans. We can use loans for major life events like buying a house or car for which we don’t have enough money to pay cash.
- Personal Loans. These loans can be used for almost anything you choose, but many borrowers use them for emergencies, to pay for vacations, or to buy new appliances. Most personal loans are unsecured, so you may have to put up collateral or agree to a fixed interest rate.
- Auto Loans. Interest rates on this type of loan are usually lower because lenders use the vehicle as collateral that can be repossessed if you don’t pay.
- Student Loans. This is used to pay for college or higher education expenses, and you may borrow from federal programs or private lenders. Using federal loans allows options to defer payments, forgive debt, or pay the money back based on your income. Private lenders generally don’t offer those options.
- Mortgage Loans. This loan allows you to buy a house and uses the house as collateral, so the interest rate is usually lower than unsecured loans.
- Home Equity Line of Credit (HELOC). Homeowners can borrow a part of the equity from their home and pay the money back over time.
- Credit-Building Loans. If you don’t have a credit history or have poor credit history, lenders may loan you small amounts of money at higher interest rates for a short period of time to build your credit.
- Debt Consolidation. This allows you to combine your current debt together into one loan so you can either pay it off sooner, have a lower monthly payment, or have fewer bills to keep track of.
- Payday Loans. Most financial experts warn against these loans because they are predatory and take advantage of borrowers because they are short term loans that charge interest rates of 400% sometimes. Amounts of loans range from $50-$1,000, but you don’t have to have credit to get this type of loan.
Why Do People Take Out Loans?
Many adults take out loans to cover expenses that we don’t have the cash on hand for.
Investors like myself use loans to purchase investments that make us more money at a low interest rate to keep our cash on hand for emergencies. (This is an investment strategy, not investment advice.)
If you have to move for a new job, you may take out a loan to cover moving expenses or a security deposit on a new apartment.
Combining your debt into one large sum is called debt consolidation, and the benefit is to reduce your monthly payment, lower your interest rate, or manage how many monthly bills you have to track.
Good Financial Habits for Managing Loans
- Avoid impulsive purchases. I always take 72 hours to think about major purchases that are over $500 before I make a decision to spend the money because I want to make sure that I actually need whatever it is that I’m buying.
- Keep a budget to track expenses. When taking out a loan, you want to make sure you pay on time and make the full payments, or this could impact your credit score. If you take out secured loans using collateral, you could lose the item if you don’t pay the loan.
- Have an emergency fund. Keeping an emergency fund that covers at least one month of expenses in a savings account that you have access to will help with money management and prevent taking out too many loans. If you have too many loans outstanding or apply for a lot of loans in a short period of time, this lowers your credit score.
- Let the lender know if you can’t pay on time. Sometimes, we may not have enough money to make a payment on time one month. If you have a good relationship with the lender, you may be able to let them know the payment will be late and have them work with you. If you don’t let them know, they won’t know that you’re struggling.
How Can Parents Teach Us About Loans
Having financial conversations with parents doesn’t have to be hard. Some of us don’t like to talk about mistakes we’ve made with money, but the benefit of having conversations with our kids about mistakes we made is that you can learn from our experiences.
Public schools don’t always teach about personal finance and may have biased views on debt and loans, so at home learning may be hugely beneficial.
Start by asking your parents if they’ve ever used loans and what for.
Then, discuss how they track what loan payments are due, to whom, and for how much. It would be helpful to have conversations about budgeting and how best to budget for loan payments.
Be careful not to judge your parents for how they have managed their money because we have all made different life choices and all make mistakes.
Ask them how they avoid making impulsive purchases or choose what to spend money on.
If your parents have advice or wisdom on how to avoid the financial errors they’ve made with loans, it may help you learn how to make good financial decisions with loans.
Loan Definitions
- Loan – money given to a borrower in exchange for a promise to pay it back with interest over a certain period of time
- Interest – money paid by a borrower to a lender in exchange for a loan
- Interest rate – percentage of a loan paid by a borrower to a lender in exchange for lending money
- Collateral – something of value given to a lender by a borrower in exchange for a loan
- Prime rate – the interest rate charged by banks and based on the Federal Reserve’s overnight rate
- Equity – how much a house is worth minus what is owed to a lender
Books and Resources to Learn More About Loans
How To Money: Your Ultimate Visual Guide to the Basics of Finance. This provides a visual guide for basic finance that’s easy to understand and a roadmap for how to make money, use money, and manage money.
I Want More Pizza: Real World Money Skills For High School, College, And Beyond. If personal finance seems too complicated or boring, this is the book you want to read because who doesn’t love pizza? Financial topics like loans and debt are broken down into relatable and easy-to-understand ways!
Rich Dad Poor Dad for Teens: The Secrets about Money–That You Don’t Learn in School! I’m partial to this book myself because this is how I started my journey into personal finance, business, and investing 20 years ago! This book offers a perspective from an employee’s point of view AND a business owner’s point of view so we can see how each uses loans differently.
Paying for College, 2023: Everything You Need to Maximize Financial Aid and Afford College. This step-by-step guide will help you navigate the financial aid and scholarship process to help pay for higher education expenses. Finding ways to save money on out-of-pocket expenses for college is a great way to save thousands of dollars!
Broke Millennial: Stop Scraping by and Get Your Financial Life Together. Written for a slightly older crowd, this beginner’s guidebook seems to be a great fit for beginners of any age because personal finance is discussed in a simple way with a lot of humor thrown in to keep it fresh!
