How do loans work?

Loans fund the big moments in life: the purchase of a car or house, paying for college, and so much more. Understanding loans, how they work, and their cost can help you better manage your finances as you pay for the finer things in life. They’re also used for not-so-fun but necessary reasons — like debt consolidation or hardship, for instance.

Let’s talk about loans and get a better understanding of how they work.

What is a loan?

A loan is money you borrow from a bank, credit union, or lender with the agreement to pay it back over a specific amount of time. When applying for a loan, the lender will check your credit score to get a better overview of your probability of making all the required payments on time. 

When you take out a loan, you agree to repay the principal (the amount you borrowed) plus interest (the cost of borrowing).

Loans are used for many reasons — like paying for college, buying a car, or covering unexpected expenses. But no matter the reason, the basic idea is the same: you borrow now and repay later, usually in uniform monthly payments.

Each payment includes:

• A portion of the principal
• A portion of the interest

The amount of interest you pay depends on the interest rate and the length of the loan. Missing payments can lead to late fees, damage your credit score, and make it harder to borrow in the future.

Different types of loans

There are many types of loans, but here are a few common ones that young people might encounter:

• Student loans: Used to pay for college or trade school. These often have lower interest rates and flexible repayment options.
• Auto loans: Used to purchase a vehicle. The car itself usually serves as collateral, meaning the car is property that the lender can seize if you don’t repay the loan.
• Personal loans: Can be used for almost anything, including emergencies, travel, or consolidating debt. These are usually unsecured, meaning they don’t require collateral.

Understanding interest

Think of interest as the cost of renting money. It’s the extra money you pay to a lender for borrowing their money.

There are two main types of interest:

• Simple interest, which is calculated only on the original loan amount.
• Compound interest, which is calculated on the loan amount plus any interest that has already been added.

What is APR?

A loan’s APR (or annual percentage rate) is a measure of the interest rate plus additional fees charged with the loan, expressed as a yearly rate. A lower interest rate and/or APR means you’ll pay less over time. Always compare APRs when shopping for a loan.

Avoiding loan scams

Unfortunately, not all loan offers are trustworthy. Here are some red flags to watch for in loan and lending offers:

• Guaranteed approval with no credit check
• Requests for upfront fees
• High-pressure tactics or limited-time offers
• Unprofessional websites or emails

Here are some proactive steps you can take to remain safe from lending scams:

• Do some online research on the lender
• Check for reviews or ratings from the Better Business Bureau
• Never share your personal information with unverified sources
• Ask a trusted adult or financial advisor for help

Our team is always here to help you sort through loan offers to verify their legitimacy and are trained to spot scams. If you feel like you want a member of our team to review things with you, stop by a branch or call one of our friendly loan officers.

What to know before taking out a loan

Before signing anything on a loan offer, protect yourself by making sure you follow these rules:

• Understand the terms. Know how much you’re borrowing, the interest rate, and how long you’ll be repaying.
• Borrow only what you need. Don’t take out more than you can afford to repay.
• Make a budget. Ensure you can make the monthly payments.
• Build credit responsibly. Paying on time helps you build a strong credit history.

Final thoughts

Understanding how a loan works is a big step toward financial independence. Whether you're planning for college, buying your first car, or just learning the ropes, knowing the basics of borrowing, interest, and repayment will help you make smart money decisions.