Sometimes, life throws big expenses your way—like paying for college, starting a business, or buying a house. That’s where borrowing money can help. Stepping into the world of loans can feel overwhelming at first—full of unfamiliar terms and endless questions. That’s why we’re here to help you understand how loans work from the very beginning.
If you’ve never explored how getting a loan works, this is the perfect place to start—simple, friendly, and totally judgment-free. We’ll walk you through everything: what loans are, how they’re approved, and what it means to pay them back (yes, that part’s non-negotiable).
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What is a loan?
“A loan is an agreement where a lender gives you money upfront, and you agree to repay it with interest over time,” says Shirley Mueller, finance specialist and founder of VA Loans Texas. Typically, you borrow money from a bank, credit union, or online lender, providing a financial boost when you don’t have cash to cover your spending.
Types of loan
“Loans are available to suit every need of the customer,” says Anna Yen, chartered financial analyst. Here are the most common types:
- Personal loans: Flexible for anything from consolidating debt to covering unexpected expenses
- Student loans: Specifically designed for tuition and educational costs
- Mortgages: Used for purchasing a home or property
- Business loans: Help entrepreneurs and companies set up and run a business
Understanding key loan terms
Taking out a loan can seem like a big step, but understanding a few key terms makes it simpler. Once you're familiar with these basics, you’ll feel more in control of the process. Below, we break down the most important loan terms to help you make informed decisions and manage your loan with confidence.
- Principal: The amount you borrow, which must be repaid with interest
- Interest rate: The percentage charged on the loan amount by the lender, which determines how much extra you’ll pay over time
- Annual Percentage Rate (APR): The total cost of borrowing, including interest and fees, expressed as an annual percentage
- Credit score: A number that represents your creditworthiness, commonly used by lenders to determine your eligibility for a loan and the terms they might offer
- Collateral: An asset (like a car or house) pledged as security for a loan—which the lender can seize if you don’t repay
- Loan term: The length of time you have to repay the loan, usually measured in months or years
- Monthly payment: The fixed amount you must pay each month, which includes both the principal and interest
- Default: What happens when you fail to repay the loan as agreed, leading to penalties, damage to your credit score, or legal consequences
- Grace period: A short period (common with student loans) during which you’re not required to make payments, typically after receiving the loan or graduating
- Hard credit inquiry: A check performed by lenders during your application process that can temporarily lower your credit score
How do loans work?
Wondering how does getting a loan work? The process of applying for a loan may seem complex, but it’s straightforward when broken into the four simple steps below.
Before applying, identify why you need the loan and how much to borrow. Whether it’s for a major expense, debt consolidation, or a specific goal, this helps you choose the right type and avoid overborrowing. Compare options from banks, credit unions, and online lenders, as terms, interest rates, and fees (like origination fees) can vary.
1. Application
Complete the application, providing information about your income, employment, expenses, and the amount you want to borrow. Be ready to submit supporting documents such as pay stubs, tax returns, or bank statements. Some lenders may also ask for details about collateral if the loan is secured.
2. Approval
The lender reviews your application, considering factors like your credit score, income, and debt. Approval times vary, and if your application is denied, the lender must provide a reason, helping you understand what to improve for next time.
3. Disbursement
Once approved, the loan amount is either deposited into your account or sent directly to the seller (e.g., when purchasing a car or home). For certain loans, like student loans, the funds might go directly to the institution or provider.
4. Repayment
How does paying a loan work? Loan repayment typically begins within 30 days of receiving the funds, although this can vary depending on the type of loan and your agreement with the lender. For example, personal loans often require payments to start the following month, while student loans usually have a grace period after graduation. Be sure to understand all the terms of the loan you’ve taken out. Payments are generally made monthly and include both the principal (the borrowed amount) and interest.
Make smart loan decisions
Taking out a loan is a significant financial commitment, so approach it wisely. Borrow only what you truly need and ensure the monthly payments fit comfortably within your budget. Always compare interest rates, terms, and fees from multiple lenders to find the best deal.
Check your credit score beforehand, as a higher score can secure better rates. If your credit score isn’t great and you have some wiggle room with timing, take a few months to try and boost your score before applying for a loan.
Finally, read the loan agreement carefully to understand all conditions, including penalties for late payments or early repayment. A thoughtful approach can save you money and prevent unnecessary stress.
FAQs
How can you decide if taking out a loan is the right choice for you?
“Deciding whether a loan is right for you depends on whether the benefits outweigh the costs,” Mueller says. So, ask yourself: “Do I truly need this loan, and can I comfortably handle the monthly payments?” If the loan helps you achieve a meaningful goal, it might make sense. However, take your time to compare options, calculate costs, and ensure the repayment terms won’t stretch your budget too thin. Covering one expense only to create an even bigger one isn’t worth it.
What happens if you can’t make your loan payments?
Missing loan payments can have serious consequences. “Lenders charge late fees on missed payments,” Yen says. “They can also apply penalty interest to the unpaid installment. Your credit score will be affected, and you may face legal action.” While some lenders may offer options like deferment or modified payment plans, these aren’t guaranteed.
Yen advises contacting your lender to explain your situation, which can lead to alternatives like deferment —a temporary pause on payments—or refinancing, which involves replacing your loan with a new one, often with adjusted terms to make payments more manageable.
Read this next: 4 Types of Loans You Can Refinance
Do loans hurt your credit?
At first, taking out a loan can impact your credit score because lenders perform a hard inquiry—a credit check that temporarily lowers your score—when reviewing your application. However, how you manage the loan is what truly matters. “You can improve your credit score by repaying the loan responsibly, making regular payments with interest,” Yen says.
On the other hand, late or missed payments can hurt your score. Even applying for a loan can cause a temporary dip due to the hard inquiry. But don’t worry—responsible borrowing and steady payments can help build strong credit over time. Ultimately, it’s about staying consistent and making informed financial decisions.