Below are common loan terms that’ll help you expand your loan vocabulary so you can make a more informed decision when borrowing money. Using a loan to finance an expense—whether it’s for an automobile purchase or home improvement project—can be a smart decision. However, if you’re not familiar with certain loan terminologies, you might be at a disadvantage when it comes to evaluating a loan or comparing loans from multiple lenders.
1. ANNUAL PERCENTAGE RATE (APR)
The annual percentage rate (APR) is the total yearly cost of taking out a loan. This rate includes the interest rate, along with any other finance charges. For example, when you take out a personal loan, you might have to pay loan origination fees. If you were to only look at the loan’s interest rate, it would be lower because the loan origination fee isn’t included.
Under the Truth in Lending Act, lenders must disclose the APR, so you have a complete understanding of how much it’ll cost to take out a loan.
When you apply for a loan and receive funds, you are the borrower. As the borrower, you’ll have to repay the loan according to the loan terms agreed upon.
3. BORROWER DEFAULT
Defaulting on a loan occurs when a borrower doesn’t pay back the loan as promised. If you’re a couple of days late on your payment, the lender might be willing to work with you. However, if they try to reach out to you for months and you don’t respond, they may send your debt to a debt collector. The debt collector could report you to the credit bureaus, which would harm your credit.
When a debt is considered in default varies by the lender and type of debt. For example, federal student loans are not considered to be in default until they are nine months past due. To find out when your loan would be considered in default, reach out to your lender or read the terms of the loan.
Collateral is an asset that you can pledge to a lender to back—or secure—a loan. Common types of collateral include real estate, vehicles, cash and investments. For example, when you take out an auto loan or mortgage, the car or house is the asset that secures the loan. If you fail to repay your loan, the lender can repossess your car or foreclose on your home. Collateral is required on secured loans; it’s not required on unsecured loans.
When someone agrees to be jointly responsible for paying back a loan with you, that person is referred to as a co-borrower. For example, if you and your partner qualify for a mortgage loan together, you’d be co-borrowers. Lenders use both the primary borrower’s—you—and co-borrower’s credit and income to qualify the applicants. If approved, both of your names would appear on the loan documents, and you would share ownership of the asset.
A co-signer is an individual who agrees to sign a loan to help someone with a lower credit score or no credit history qualify for a loan. If you co-sign for a loan, you’ll be held responsible for repaying the loan if the primary borrower defaults on the loan or misses a payment. This also can damage your credit, not just the primary borrower’s credit.
7. CREDIT SCORE
Before approving your loan, lenders will check your credit score to assess how risky of a borrower you are. Some will use your FICO credit score, which ranges from 300 to 850. Your score is calculated based on the following factors:
- Payment history: 35%
- Current debt amount: 30%
- Credit history length: 15%
- Credit mix: 10%
- New credit activity: 10%
The best interest rates for loans usually go to borrowers who have good to excellent credit scores. Based on the FICO credit model, a good credit score is at least 670.
8. FIXED INTEREST RATE
When a loan has a fixed interest rate, the interest rate remains the same for the duration of the loan. Since the interest rate remains the same, the monthly payment doesn’t change. The predictable monthly payments make it easier for you to budget your loan payments.
9. GRACE PERIOD
During a student loan’s grace period, the borrower isn’t responsible for making repayments. However, interest usually accrues (except on direct subsidized loans) during this time and you can choose to pay it. Loan grace periods typically take place after you graduate, drop below half-time enrollment or leave school. For example, some federal student loan borrowers have a six-month grace period after they graduate.
10. GROSS INCOME
Your gross income is the total amount of income you earn before taxes and other deductions are taken out of your paycheck. When considering whether to lend you money, a lender may use your gross income to calculate your debt-to-income ratio (DTI). This ratio compares your monthly income with the amount you spend on debt each month. By looking at this ratio, a lender can gauge how much money to lend you.
11. HARD CREDIT CHECK
When you apply for a loan, the lender will perform a hard credit check or inquiry. This credit inquiry usually has a small impact on your credit score—your score may drop by up to four points. A hard credit check remains on your credit report for two years. However, some credit reporting agencies, like MyFico, only consider hard credit checks from the past 12 months.
12. INSTALLMENT LOAN
An installment loan is a loan with a fixed repayment period listed in the loan agreement. For example, let’s say you take out a personal loan to refinance high-interest debt. Once you receive the lump sum payment, the lender will require you to make monthly payments or installments to repay the loan.
13. LOAN AMORTIZATION
To create a fixed repayment schedule for fixed-interest rate loans, lenders use loan amortization. It’s a process that involves calculating how much money will go toward the principal and interest for each installment payment.
14. LOAN AGREEMENT
A loan agreement is a legal contract between you and the lender. In this agreement, you’ll find important information, such as:
- Your total repayment amount, including principal and interest
- Annual percentage rate
- Late charge amount
- Payment schedule
- How to repay your loan
- What happens if you default on your loan
Reading this agreement is important because some lenders include information on how you can use the funds. For example, when taking out a personal loan, most lenders prohibit you from using the funds for education expenses or investing.
15. LATE FEE
If you make a past due payment on your loan, your lender may charge you a late fee. The amount of this late fee and when the lender charges it varies according to the lender. For example, some lenders might not charge you a late fee until your payment is 15 days late. This information can be found in your loan agreement.
16. LOAN DEFERMENT
When you encounter financial hardship, some lenders will allow you to do a loan deferment. During this time period, you won’t be responsible for repaying the loan. However, your loan may continue to accrue interest. The deferment extends the loan term, which can increase your overall cost of borrowing funds.
17. LOAN LIMIT
The maximum amount a lender will loan you is your loan limit. A lender will allow you to borrow a certain amount of money based on your income, creditworthiness and DTI. Although a lender may allow you to borrow more than you can afford, it’s wise to consider your budget before borrowing the maximum amount of money.
18. LOAN ORIGINATION FEE
Some lenders charge origination fees for expenses related to your loan, which are deducted from the loan amount. This fee covers the lender’s costs of underwriting, processing and administering your loan. For example, if a lender has a 5% origination fee and you borrow $10,000, you’ll receive $9,500 in your account ($10,000 – $500).
19. LOAN TERMS
Your loan term is the amount of time you have to repay your loan. For example, if you take out a six-year auto loan, the loan term would be six years.
20. NON-RECOURSE LOANS
A non-recourse loan is a loan that’s secured by collateral. In the event that you default on your loan, the lender can seize the collateral attached to the loan. However, the lender doesn’t have a right to seize any additional personal property.
21. PREPAYMENT PENALTY
Some lenders will charge you a prepayment penalty if you pay off some or all of your loan balance before the end of the loan term. For example, some mortgage companies will charge you 2% of the remaining principal balance if you make early payments. Federal law forbids lenders from imposing prepayment penalties on Federal Housing Administration (FHA) mortgages and student loans.
The amount of money you agreed to borrow is considered the principal. As you repay your loan, the principal balance decreases. The principal amount does not include the interest you owe.
23. RECOURSE LOANS
When you take out a recourse loan, it is secured by collateral. If you default on your loan, the lender can seize the asset attached to the loan. In addition, they may be able to go after other personal assets if the asset attached to the original loan isn’t enough to satisfy the debt.
24. SECURED LOAN
A secured loan is one that has collateral attached to it. If you default on the loan, the lender can seize the asset. Some common examples of secured loans are home equity loans, auto loans and mortgages.
25. SOFT CREDIT CHECK
Soft credit checks occur when you view your own credit, apply for a job or give a lender permission to do a quick review of your credit. A soft credit check has no impact on your credit score. Allowing a lender to perform a soft credit check is useful when prequalifying for a loan. By prequalifying, your lender can give you an estimate of what your loan’s APR and terms would be if you apply.
To secure the best interest rate possible, it’s a good idea to prequalify with multiple lenders to compare rates.
26. UNSECURED LOAN
An unsecured loan is one that doesn’t have collateral attached to it. Some common examples of unsecured loans are credit cards, personal loans and student loans. When you take out an unsecured loan, the lender cannot seize your personal assets, unless they are awarded a judgment by a court.
27. VARIABLE INTEREST RATE
When you take out a loan with a variable interest rate, the interest rate fluctuates based on a benchmark rate specified in the loan agreement. A common example of a financing option that typically has a variable interest rate is a home equity line of credit. How often the interest rate adjusts varies depending on the lender. If you choose a loan with a variable interest rate, your payments could increase or decrease over the life of the loan.
Jerry Brown – Forbes Advisor