Loans 101 (Loan Basics 1/3)

Meet Lucy. Lucy has been working at Corporate
Co. for the past three years. Since her very first day on the job, Lucy
has seen her colleagues refinance students loans (Zoe), purchase cars (Joan), and even
buy houses (Emily). Lucy wants to be like them, there’s just
one problem: all these activities require loans, and Lucy just doesn’t feel confident
handling them. What should she to do? Well, her first step is simple: understand
how loans work. On their most basic level, loans are simply
borrowed money. Lenders, such as banks, can give borrowers, such as Lucy, a fixed amount
of money called principal, like $10,000 to buy a car. However, the bank isn’t giving
Lucy this money for free. In addition to paying back her principal, they’ll require Lucy
to pay a certain amount of money each month, called interest, just for using their money.
In addition, if her loan is secured, as many are due to their more attractive interest
and approval rates, the bank can seize actually the asset, in this case her car, if she fails
to repay. So how is this interest calculated exactly?
Let’s explain through an example. Let’s say Lucy’s $10,000 car loan comes
with a 5% annual interest rate. Divide that 5% by 12 months, and you get roughly 0.4%,
the monthly interest rate. That’s means Lucy owes the bank 0.4% of her outstanding
principal each month in interest. While this seems reasonable enough, interest
rates come with three more complications: One: Not all interest rates are fixed. Some,
called variable interest rates, can change over time, often quite dramatically. Because
of this, they can be quite risky, especially on long-term loans.
Two: the interest rate of a loan is not the same thing as its APR. APR includes both the
interest rate, either fixed or variable, and the fees. Thus, when comparing loans to see
which is cheaper, Lucy should always use APR, not the interest rate.
Three: APRs are also highly dependent on your credit score, as the lower your score, the
higher your APR. For more details on this, be sure check out our next video “Credit
Scores and Reports 101”. So that’s interest rates. But unfortunately,
they aren’t Lucy’s only concern. She also must pay back a certain amount of her principal
each month. This payment, combined with interest, makes up Lucy’s total loan payment, which
is the money you pay the bank each month. Should Lucy want to calculate this number
herself, all she’ll need is an online calculator, like ours, and three numbers: the amount of
money borrowed, the interest rate, and the length of the loan, also known as its term. This term is a critical number, especially
when choosing a loan. That’s because, in general, the shorter
the term of the loan, the greater your monthly loan payment. This should make sense. After
all, the less time you give yourself to repay the loan, the more you’ll have to pay each
month to compensate. And while this may seem bad, shorter term
loans can actually be great, for two reasons. One: They come with inherently lower interest
rates. And two: Because their monthly payments are
much larger, the borrower is forced to pay down the principal much faster, which ultimately
means less interest charged over the life of the loan. This fact is so important that we’ll repeat
it. The shorter you can make your loan, either through extra-debt repayments or a shorter
term, the less interest you’ll pay in the long-run. Hopefully you and Lucy now better understand
how loans work. Be sure to watch our next video, which covers everything you need to
know about credit scores, and be sure to check out our website, where you can find more educational
material, your free credit score, and great loan recommendations.

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