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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.