Loans can provide an opportunity to buy a new vehicle or home, or provide short-term cash in an emergency. Understanding how loans and credit lines work are critical to financial health, so brushing up on the basics can help you be a more responsible borrower.
A loan is a business contract between borrower and a lender. Those two parties are often a bank customer and a bank, respectively. A loan contract indicates that you get a lump sum of money now, with the expectation that you’ll pay it back to the bank later, usually with interest included. A term loan means a borrower will lend a certain sum of money in exchange for certain loan terms. These are commonly used by small businesses or individuals purchasing a large asset, like a home or a building. Term loans can offer lower interest rates and more flexibility.
Interest is the amount it costs for the bank to lend you money. The loan typically includes a percentage fee, or interest, as a cost of borrowing. That interest rate may be fixed throughout the term of your loan, or it may change. Variable interest rates can potentially change, according to the terms of your contract.
Variable interest rate is an interest rate that might change, according to the terms of your contract. An example of a common variable interest rate is a credit card with an introductory 0% annual percentage rate (APR) that then goes up to 15% once you’ve had the card for a year. Other loan types like student loans and adjustable-rate mortgages can include a variable interest rate as well.
Fixed interest rate is an interest rate that stays the same throughout the loan. Fixed interest rates don’t change, even when there’s inflation or a change in your payback habits. Credit cards don’t usually have fixed interest rates, but things like car payments and mortgages often do.
Open-end credit is a type of loan where you can make repeated withdrawals and payments with no final amount you’ll pay back. Credit cards and home equity loans are open-end lines of credit.
Closed-end credit is a type of loan in which all the funds are lent at once, and all the funds must be paid back. When the credit extended to you doesn’t have a set term, or end date, it is considered open-end credit. Credit cards are an example of open-end credit. Closed-end credit, on the other hand, has a set term. For instance, many mortgages are repaid over 30 or 15 years, making them a good example of closed-end credit.
A secured credit card is a credit card that requires a cash deposit to open an account. Secured credit cards are a common tool to help build credit history. With this type of credit card the bank can use the cash deposit as collateral if you fail to make payments.
Learn more about credit and lending.