A Little Lesson on Loans

The opportunity to spend money is everywhere. There is no shortage of places that will take your cash. In fact, to keep the money flowing out of your wallet, banks and merchants continually come up with easier ways for you to spend it.

But when it comes to borrowing money, suddenly the cash pipeline doesn't operate so smoothly. Money becomes a more complex issue with documents and terminology that practically require you to have both an MBA and Law degree to fully understand.

Before you get dazed by the paperwork and lost in the legalese of loan products, here is a quick lesson on loans.

1) The Basics
When you get a loan, you are borrowing money with a promise to pay back the original amount (principal) plus an extra amount as a fee (interest) for the privilege of borrowing. The amount you pay in interest is normally a percentage of the loan amount -- the interest rate.

Example: If you borrow $100 with an interest rate of 10%, you will pay back $110. That consists of the $100 principal plus $10 interest.

2) Loan Categories
From a broad perspective, loans fall under one of two categories: a) Installment loans and b) Revolving Credit loans.

a) Installment loan: The installment loan is probably what most people think of when talking about a loan. Money is borrowed from the bank in one lump sum and normally paid back in installments, or increments, over a set period of time. The sum paid back can include both the principal plus interest or the payments may contain interest only with the principal being paid all at once in the last loan installment, known as a balloon payment.

Loans that fall under this category include mortgages, personal loans, and auto loans.

b) Revolving Credit loan: Revolving Credit (also called Revolving Line of Credit or Credit Line) is a loan where a lender allows someone to borrow money up to a specific limit, called the credit limit, whenever money is needed. The borrower draws down the credit limit every time an amount is borrowed. The borrower can use as much of the credit as he or she wants. When a repayment is made, the available credit rises by the paid amount.

Example: Borrower gets a credit limit of $1000. $100 of the credit is used to buy merchandise. The credit limit now decreases by $100 to $900. A day later, the borrower decides to borrow another $100 decreasing the credit limit to $800. Next month, borrower pays back the $200 plus interest and the credit limit goes back to the full $1000.

Loans that fall under this category include credit cards, home equity line of credit (HELOC), and business lines of credit.

3) Rates
As you already learned, the interest that you pay is calculated as a percentage of the principal amount. Some loans have a fixed interest rate while others have an adjustable rate of interest.

A loan with a fixed interest rate means that the interest you pay stays the same throughout the life of the loan.

The adjustable rate loan, on the other hand, has an interest rate that can fluctuate from period to period. That means a borrower can expect to pay more or less interest as the rate fluctuates. The rate's movement is tied to indexes that track a basket of interest bearing investments. As the interest rates of the index moves up or down, the interest rate on your loan is adjusted accordingly.

There you have it. You just completed your lesson on loans. Now that you have a grasp of the basics of loans, you will be better prepared to understand the minute details of the loan that you need.

Jon Galanty is a financial writer for eMoneyCentral.com. Visit http://www.emoneycentral.com to find out more about loans and to get other great money tips.