Updated: Jan 31
The following article has been adapted from FME Articles, a partner organization of Finance OneforOne. To read a longer version of this article, click here
Almost every American has a mortgage for their house or a loan of some kind. Despite this fact, many do not know what exactly a loan is. This article will cover loans and how they work.
A loan is a financial transaction (an exchange of money) between two entities where one party lends money to the other with the intention of being paid back in regular periods (months, years, etc.). For example, if the loan is $5000 (the amount lent) over 12 months (regular period - months), the other party would pay back $5000/12~$417 plus interest over this time. Plus interest.
The interest is a percentage that adds to the amount paid back. This way, one party benefits from being paid back more money, and the other from having money to spend that’s not theirs.
The interest rate is determined by current market rates (determined by the Federal Reserve - out of the borrower’s control) and the amount of risk involved (determined by the borrower’s qualifications). The lower the risk involved is, the lower the interest rate is.
In the previous example, the interest was 0%. This never happens. There is always some risk and some outside factors involved, so the interest rate is always present. Use this calculator to determine how much you need to pay each month on a loan as interest rates vary.
A mortgage is a type of loan that has to do with properties. Like most loans, the borrowers of mortgages have to meet certain qualifications like having a good credit score and stable income. This way, the lender will make sure the money will be paid back. The better these qualifications, the less the interest rate (as there are fewer risks involved). The borrower receives a principal amount (the amount that is loaned without the interest) and pays back the principal amount plus interest.