Personal Loan Terminology: Essential Terms to Know Before Taking Out a Loan
Taking out a personal loan is a significant financial commitment, and it’s crucial to have a clear understanding of the terms involved before signing any agreements.
Financial jargon can often be confusing, but with this comprehensive glossary, you can confidently review your loan agreement and comprehend every clause.
From APR to cosigners vs. co-borrowers, we’ve got you covered.
What is a Personal Loan?
To begin, let’s define what a personal loan is: it is a type of loan that is disbursed in a lump sum and then repaid in equal installments over a set period.
There are several types of personal loans, and many are unsecured, meaning that there is no collateral required.
People use personal loans for a variety of purposes, including home improvements, debt consolidation, and vacations.
Main Terms in a Personal Loan Agreement
To make the loan process smoother, it’s essential to familiarize yourself with personal loan terminology.
Amortization
Amortization refers to the schedule of loan repayment over the life of the loan, which the lender creates when processing the loan. An amortization schedule outlines the amounts of principal, interest, and escrow (if included) in each payment.
A loan can also be re-amortized, for instance, if you are considering making a lump sum payment on the loan, the remaining repayments can be recalculated.
This information allows you to determine the change in interest owed over the loan’s lifetime and how much faster the loan could be paid off, and if the extra payment is worth it for your financial situation.
Annual Percentage Rate (APR)
The APR is the percentage of the loan principal that you will pay in interest over the course of a year, including any fees charged by the lender.
Application Fee
Some lenders may require you to pay a fee when you apply for a loan. Not all lenders charge an application fee, so it’s best to shop around to find one that doesn’t.
Automatic Payment
Many lenders offer the option of setting up an automatic payment that will be deducted from your bank account on the loan’s monthly due date.
This can simplify your financial management, but make sure there are sufficient funds in the account each month to avoid overdrafts.
Borrower
The borrower is the person or entity taking out the loan.
Collateral
Collateral is an asset offered by the borrower to secure the loan, reducing the risk for the lender.
For example, in a mortgage, the home serves as collateral, which is why the bank can foreclose and sell the home if the borrower defaults.
Similarly, in an auto loan, the car serves as collateral, which is why it can be repossessed if the borrower fails to make payments.
Co-borrower
If a loan application does not have strong enough financial credentials to be approved for a loan, they may add a co-borrower to the application.
The co-borrower, who has a more robust financial profile than the primary borrower, is also responsible for the loan.
Co-borrowers apply for a loan together and typically have shared ownership of the borrowed money or the asset purchased.
For example, you and your spouse may apply as co-borrowers for a jointly-owned car loan.
Cosigner
A cosigner is a person who acts as a co-borrower to increase the chances of loan approval for the primary borrower.
For example, a parent may cosign their child’s student loan, but they do not have ownership of the loan or its proceeds.
They are only responsible for making payments if the primary borrower fails to do so.
Credit Agency
A credit agency also referred to as a credit bureau, is a company that collects and maintains information about an individual’s or business’s credit history.
They calculate credit scores and provide them to creditors upon request.
The three major credit bureaus in the U.S. are Equifax, Experian, and TransUnion, and you can obtain a free credit report from each of them once a year at AnnualCreditReport.com.
Credit History: Credit history refers to an individual’s history of borrowing and repaying debt.
It is reflected in their credit report and can be positive or negative, depending on their track record of timely debt repayment.
People with no credit history typically have no record of borrowing or repaying debt.
Credit Report
A credit report is a comprehensive document that details an individual’s credit history, including their payment history, open and closed accounts, default or collections, bankruptcies, liens, judgments, and other financial information.
It is important to regularly check your credit report for accuracy and make any necessary corrections.
Credit Score
A credit score is a numerical representation of an individual’s creditworthiness. The most commonly used credit score by lenders is the FICO® Score, which ranges from 300 to 850.
The VantageScore, which also ranges from 300 to 850, is used less frequently.
The higher an individual’s credit score, the lower the credit risk lenders consider them to be. The average credit score for consumers in the U.S. is 716 (FICO).
Debt Consolidation
Debt consolidation is a debt repayment strategy where one large debt, such as a personal loan, is taken out to pay off multiple smaller debts, such as credit cards.
This can simplify monthly finances by reducing the number of payments to be made, potentially lowering interest costs and monthly debt payments, making it easier to meet financial obligations.
Default
Not repaying a loan as agreed, such as missing payments, is known as defaulting and may lead to the loan being sent to collections.
Fixed Interest Rates
Interest rates that remain constant throughout the loan term are known as fixed interest rates.
Borrowers will pay the same amount of interest on the loan for the entire duration. Comparing personal loan rates from multiple lenders can help find an appropriate rate for one’s financial situation.
Variable Interest Rates
Interest rates that fluctuate with market conditions are referred to as floating or adjustable interest rates.
Guarantor
A guarantor acts as a support for a loan application, much like a cosigner or co-borrower.
Like a cosigner, a guarantor does not have ownership of the loan proceeds or assets purchased with it.
The key difference between a cosigner and a guarantor is that the latter will only be required to repay the loan if the primary borrower defaults.
Gross Income
Gross income is the total amount of money earned annually from work, investments, and other sources before taxes and deductions are taken out.
Installment Loans
Installment loans are loans that are repaid through regular monthly payments. Personal loans, car loans, and mortgage loans are examples of installment loans.
Interest Rate
The interest rate is the percentage fee charged for borrowing money, excluding any additional fees or charges associated with the loan.
Hard Credit Check
A lender may perform a hard credit check, also known as a hard inquiry when a loan or line of credit is applied for.
Excessive hard credit checks in a short time frame may have a negative impact on one’s credit score.
Late Payment
Making a debt payment after its due date is referred to as a late payment.
Late payments can significantly harm one’s credit score, as payment history is a major factor in determining creditworthiness.
Lender
A lender is an entity providing the money, which could be a bank, credit union, or an individual such as a friend or relative.
Line of Credit
A Line of Credit is a financing option for individuals who don’t require a lump sum amount at one time. It is a credit limit that enables the borrower to withdraw funds as and when needed, rather than all at once. The borrower can repay the funds and withdraw again, up to the credit limit.
Loan Agreement
A Loan Agreement is a legally binding contract between the borrower and lender that outlines the details of the loan.
It specifies each party’s rights and responsibilities and contains information such as the loan amount, interest rate, APR, potential fees, payment schedule, and more.
It’s crucial to thoroughly read the loan agreement and clarify any doubts before signing.
Origination Fee
An Origination Fee is a one-time charge some lenders might impose when a loan is initiated, which compensates the lender for the work involved in setting up the loan.
The fee is usually a percentage of the principal amount and varies among lenders.
Payday Loans
Payday Loans are small, short-term loans meant to provide temporary financial assistance until the next payday.
Despite their low balances, these loans can be incredibly expensive, with rates around 400% APR, according to the Consumer Financial Protection Bureau.
It is generally recommended to avoid payday loans in favor of more cost-effective loan alternatives.
Payment Terms
Payment Terms refer to the conditions and terms agreed upon by the borrower when signing the loan agreement.
The payment terms can include the loan duration, monthly repayment amount, late payment charges, and other loan-related details.
Prepayment Penalty
A prepayment penalty is a fee charged by some lenders when a borrower pays off their loan ahead of the scheduled final payment date.
This fee is imposed as the lender stands to make less profit from the loan if it is paid off early, and the fee helps to compensate for that loss.
Principal Amount
The principal amount of a loan refers to the original sum borrowed, exclusive of interest and fees.
For instance, if you take out a $10,000 personal loan, the $10,000 represents the principal amount. You’ll repay the lender more than that over the loan’s lifetime, once interest is factored in.
Revolving Credit Facility
Revolving credit allows the borrower to access funds as and when required, up to the credit limit, by making at least a minimum payment each month when there is an outstanding balance.
Credit cards are a common example of revolving credit.
Secured Loan
A secured loan requires the borrower to provide collateral, an asset that they own, to the lender as security for repaying the loan.
In case the borrower defaults on the loan, the lender has the right to seize the asset to repay the loan.
Examples of secured loans include mortgages and auto loans.
Unsecured Loan
Unsecured loans are based on trust between the lender and borrower, as the lender trusts the borrower to repay the loan without requiring collateral.
However, unsecured loans usually carry higher interest rates than secured loans, due to the higher risk they present to the lender.