Getting a loan is a serious move for any person. You need to fully understand what you are getting yourself into before signing the loan contract. However, many don’t bother to read their debt agreement and just sign the papers because of the unfamiliar and confusing financial terminologies they contain.
Below you’ll find explanations of the seven most common terms that you need to understand before entering a loan agreement.
When you apply for a loan, the lender will look at your credit risk. This term refers to the bank’s likelihood of losing money because the debtor fails to meet the loan’s terms and conditions.
A creditor usually measures this risk by looking into your credit history, the capability to repay, collateral availability, and other loan conditions. Credit risk is crucial because it’s a significant factor in determining the interest rate and even the loan term.
Term of A Loan
A loan term is the maximum number of months or years you need to repay your loan. You don’t have to finish the entire length of time to settle your loan.
If you can clear up your loan obligations in advance, you can do so. Often, your loan’s interest rate gets higher the longer the term. Personal loans usually have terms of 12 to 60 months, while home mortgages can have a 30-year repayment schedule.
Collateral is simply an asset, like a car or house, that you pledge to surrender to the lender if you can’t repay your loan. You need to provide collateral if you are applying for a secured loan.
The lender’s risk is lower because you have an asset to back up the amount you owed. As a result, the interest rate for a secured loan is typically low.
Meanwhile, you don’t need collateral if you’re getting an unsecured loan. This type of debt usually fetches higher interest because there isn’t anything of value that backs up the credit. Salary or credit card debts are examples of unsecured obligations.
Many people who have multiple loans may default or miss payments on some of their debts because having different due dates can be confusing.
One way to make repayment more manageable and straightforward is through debt consolidation or merging the balances from various debts into just one big loan.
Debt consolidation is often applied to pay off credit card debts. This option has pros and cons and may depend on your circumstances. Do your research before deciding to consolidate your debts.
Principal and Interest Rate
In your loan agreement, the principal means the original amount that you owe. It doesn’t include interest or other fees that may come with the loan. Meanwhile, the interest rate is simply what the creditor charges you for the use of their money. The interest is a minor percentage of the principal amount.
Two of the most common types of interest rates are fixed and adjustable. A fixed-rate doesn’t change for the entire duration of the loan term.
So, if you get a fixed mortgage at 5%, the interest rate for the whole life of your mortgage is 5%. Meanwhile, adjustable interest rates fluctuate, depending on the market. Sometimes, it makes sense to get a variable rate if the present interest rate is high and you believe that rates will go down in the future.
Amortization is another financial jargon that many borrowers should consider before taking on a loan. It’s simply a method of spreading the debt into a series of affordable fixed payments until the obligation is entirely paid by the end of the term. As you settle your monthly amortizations, the amount you owe, which includes interests, gradually gets smaller until such time that it gets to zero balance at the end of the loan term.
Aside from interest, your lender might include additional fees in the terms and conditions of your loan. If you look at the contract carefully, you’ll see different types of other charges that your lender might impose. These include:
- Processing Fee – Covers administration costs that are associated with the loan.
- Originator Fee – Charged for securing a mortgage.
- Application Fee – You pay this only when your loan gets approved.
- Late Payment Fee – If you can’t pay your amortizations on time, your creditor may charge penalties for late payments.
- Prepayment Fee – Lenders earn money from interest. So, if you prepay your loan, your creditor may impose a small percentage of the remaining loan balance covering their income loss because you settled your debt early.
When securing a loan, you must understand the given terms. It’ll be hard for you to comprehend the contract if you’re unfamiliar with the common terminologies. It would be best to brush up on the terms enumerated above before you borrow money.