Five financial terms to know before getting a loan
Whether you’re opening a new loan or renewing an existing one, there are a few financial terms that are important for you to know and understand so you can make informed borrowing decisions.
To help you be as informed as possible, we’ve put together a list of five financial terms that you should know before getting a loan.
Amortization is essentially the period of time over which you’ll pay off your debt (principal and interest). A mortgage is a great example of a loan with an amortization period. You borrow money to purchase a home, and agree to pay it off over a set period of time, typically 20 or 25 years, which is your amortization period. At the end of that time, your debt (and interest) will be paid off and you’ll own your house in full. The length of your amortization period is one of the factors that impacts how much your payments are.
2. Daily simple vs compound interest.
When you’re borrowing money you’ll be charged either daily simple interest, or compound interest. It’s important for you to understand the difference between the two because you could end up paying a lot more in interest if you don’t.
Daily simple interest. This is usually the type of interest charged on personal loans. Daily simple interest is calculated every day based on your outstanding balance. From the date of your last payment to the date of your next payment, interest builds. After your next payment, when your balance goes down, interest is calculated on the lower balance. With daily simple interest, interest is only charged on the amount you owe each day.
You can learn more about simple daily interest here.
Compound interest. With compound interest, you’re charged interest not only on the initial amount you take out, but also on the interest you’ve already been charged if it hasn’t been fully paid off. This is more common with revolving credit like a credit card.
You can learn more about compound interest here.
3. FICO (or credit) score.
FICO stands for Fair Isaac Corporation, a company who uses predictive technology to assign you a “score” based on your past credit history, and current debt-to-income ratio. The higher your score the more likely it is (to them) that you will pay your debts. It’s important to know and understand your FICO score, as it can have a big impact on your finances, from whether you’re able to borrow money to what your interest rates will be.
4. Bill or debt consolidation.
A bill consolidation loan is when you take multiple debts and combine them, then pay them all off. Essentially you take out a loan that will cover the cost of paying off all of your debts at once, then pay back the consolidation loan, which has a set interest rate and planned payments. Often times this will help you save on interest, and it can also have the advantage of making paying down debt easier (paying one company a set amount per month is less to juggle than paying multiple companies on different dates).
5. Unsecured vs Secured loan.
When taking out a loan, you can either take an unsecured loan or a secured loan.
An unsecured loan is one that is not backed by collateral (an asset, like a person’s house). This typically means the interest rates will be higher, and the amount you can borrow will be lower as banks or other lenders don’t have any collateral to help ensure payment.
A secured loan is one which is backed by collateral to ensure payment, typically a person’s house. Because you are using collateral you can usually get a lower interest rate, and take out a larger sum of money. However, if the loan isn’t paid, the bank or institution could ultimately take ownership of the collateral to pay off the debt owed.
You can learn more about the different types of loans here.
Now that you have a better idea of some of the most common financial terms you should know before getting a loan, you’ll be prepared to discuss your loan options and choose the right one for you.