Types of Loans and Borrower Responsibilities

What a loan is

A loan is money you borrow now and promise to pay back later, with extra money added for the lender's trouble and risk. Four words come up in every loan:

• Principal ($P$): the amount you borrow.

• Interest: the fee you pay for using someone else's money.

• Interest rate ($r$): the interest per year as a percent of the principal. On a loan it is often quoted as the APR (annual percentage rate).

• Term ($t$): how long you have to repay, usually in years or months.

Total repayment = principal + interest. Lenders earn money from interest, and the interest also pays for the risk that some borrowers will not repay.

Secured and unsecured loans

Lenders worry about one thing: will I get my money back? They handle that worry in two ways.

A secured loan is backed by collateral: property the lender can take if you do not repay. Examples:

• A mortgage: the house is the collateral.

• An auto loan: the car is the collateral.

An unsecured loan has no collateral. The lender relies on your signature, your income, and your credit history. Examples: most credit cards, many personal loans, and payday loans.

When a borrower stops paying as agreed, the loan is in default. On a secured loan the lender can repossess a car or foreclose on a house, sell it, and use the money to cover the debt. On an unsecured loan the lender can send the debt to collections or sue, and your credit score drops.

How much does a loan cost?

Many short loans use simple interest, which is charged only on the original principal:

Here $r$ is the yearly rate as a decimal and $t$ is in years. The total you repay is $A = P + I$. If the loan is paid in equal monthly payments:

Why does it work? Each year you owe $r$ of the principal, so after $t$ years the fee is $P \cdot r$ added $t$ times.

Comparing two offers

A lower monthly payment is tempting, but a longer term usually means more total interest. Let's compare $\$5{,}000$ at $6\%$ for 5 years against $7\%$ for 3 years.

• $6\%$, 5 years: $I = 5000 \times 0.06 \times 5 = \$1{,}500$. Total $\$6{,}500$, over 60 months is about $\$108.33$ per month.

• $7\%$, 3 years: $I = 5000 \times 0.07 \times 3 = \$1{,}050$. Total $\$6{,}050$, over 36 months is about $\$168.06$ per month.

The 5-year loan has the lower payment but costs $\$450$ more in total, even though its rate is lower.

Payday loans: very short, very expensive

A payday loan is a small, short-term, unsecured loan, often due on your next payday about two weeks later. Instead of an APR, the lender charges a flat fee, which looks small. Convert it to an annual rate to compare it fairly:

1. Fee ÷ amount borrowed = percent cost for the period.

2. Multiply by the number of periods in a year, $\frac{365}{\text{days}}$.

A credit union small loan might charge $18\%$ APR. The payday loan costs more than twenty times as much. Worse, if you cannot repay in two weeks you may "roll over" the loan and pay the fee again, which can trap borrowers in debt.

Borrower responsibilities and cosigning

Borrowing is a contract. A responsible borrower should:

• Read the terms: APR, term, fees, penalties for late or early payment.

• Pay on time, every time. Late payments bring fees and lower your credit score.

• Borrow only what the budget can handle. Check that the monthly payment fits your income after other bills.

• Keep the collateral safe, for example by insuring a financed car.

• Contact the lender early if you cannot pay. Many lenders will work out a plan.

Good habits make you a low-risk borrower, which earns lower rates later.

Cosigning

A cosigner signs a loan with the main borrower, usually because the borrower has little or no credit history. A cosigner is not a reference. The cosigner is legally responsible for the whole debt if the borrower does not pay. The loan also appears on the cosigner's credit report, and missed payments hurt both people's credit.

Choosing between loans

To pick a loan, check four things: total cost, monthly payment versus your budget, default risk (what you lose if you cannot pay), and your responsibilities.

Mateo's two options for $\$12{,}000$:

The online loan costs $\$360$ less in total but demands about $\$163$ more every month. The bank loan is easier on the budget, but the car is collateral and can be repossessed after a default. A good answer weighs these facts against Mateo's income and savings.

Back to Mateo: his lender asks for collateral (the car) or charges a higher rate without it, and the cost depends on the rate and term.

Summary