What is a loan? (And how do loans work, anyway?)

When you want to buy something big — like a car or house — you may not have enough money to pay in full. That’s where loans come in. A loan is an amount of money you borrow from a financial institution and pay back later (usually with interest).

Families go through big life events together. Cross-country moves, new cars, college. If you’re a parent, you know exactly what we mean. 

Parents want to provide their families with financial support (no matter what they’re going through). Big life events are often both exciting AND expensive. Loans can be a helpful way to support your family through these transition periods. But borrow wisely: They’re also a long-term financial commitment that should be taken seriously. 

Let’s dig into a few things to keep in mind when deciding if a loan is right for you and your family.

How does a loan work?

Now that you know the definition of a loan, you may be wondering how they actually work. Good news: Most loans work the same way. The borrower (you) submits an application to the lender (the financial institution). The lender reviews your application and sends you an agreement. The loan agreement outlines the principal loan amount, interest rate, monthly payment amount, and loan term.

So, what do those terms mean? Good question.

• Principal loan amount: The amount of money you borrow 

• Interest rate: The percentage of your loan amount that the bank charges in addition to the principal loan amount 

  • Note: Some types of debt — like mortgages and student debt — charge compound interest. Compound interest = interest charged on interest. 

• Loan term: The length of your repayment period 

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Let’s look at how loan payments work in action. 

This brings your total loan amount to $14,700, or $306.25 per month. Woah. That's a considerable cost.

What are the different types of loans?

Before you apply for a loan, ask: “What do I need the money for?” What you’re buying often informs the type of loan you need. 

Here’s what you need to know about the six most common types of loans.

Student loan

A student loan pays for college education and living expenses, including tuition, books, and supplies. Students then pay the money back in monthly installments after graduation.

Student loans are very common in the U.S. The average public university student borrows $31,410 for their undergraduate degree.

Greenlight tip: Say hi to Investing for Parents and start saving for college with any amount — big or small.

Mortgage

Interested in buying a house? A mortgage can help you get there. These types of loans pay for homes, apartments, or condos.

You can get pre-approved for a mortgage before you ever submit an offer for a house. Pre-approval usually improves your odds of being chosen by the seller. Once you close on the property, you’ll pay monthly installments for up to 30 years on average. 

If your down payment is less than 20%, you’ll also need to pay mortgage insurance. This protects the lender if you default on the loan. 

Auto loan

An auto loan pays for — you guessed it — a car. 

Auto loans are similar to mortgages because you pay a down payment and monthly installments. Typically, auto loans are paid off in three to five years.

Personal loan

Personal loans cover just about any personal expense. They’re often used for weddings, vacations, medical expenses, or consolidating debt. 

Personal loans are just like the other loans we’ve covered. Once you’re approved, the financial institution releases the money, and you pay it back in monthly installments. Personal loan terms have a wide range but tend to be less than five years. 

Payday loan

Payday loans are short-term loans with high interest rates. Typically, they’re used to cover essentials — like groceries and rent — in a pinch. They provide you with small sums of cash (usually less than $500) that you pay off with your next paycheck. Ding, ding, ding! That’s why they’re called payday loans.

Home equity loan

Home equity loans leverage your home equity, which means you’re able to borrow up to the amount of equity you have in your house and use your home as collateral. For example, if you’ve paid $100,000 toward your mortgage’s principal balance, you can borrow up to that amount.

Your house serves as collateral on both home equity loans and mortgages (meaning the bank can foreclose on your house if you can’t pay these loans off). The difference? A mortgage is used solely to pay for your house, whereas a home equity loan leverages your house to pay for other things.

What is a secured vs. unsecured loan?

All loans fall into one of two categories: secured or unsecured. A secured loan is secured by collateral, meaning the financial institution will seize your property or assets if you can’t pay them back. Auto loans are a good example of this. The bank assumes the rights to your car if you are no longer able to pay off the loan. 

Unsecured loans don’t need collateral. Instead, the lender sends your loan to collections, and the unpaid loan will impact your credit score. Some student loans and personal loans are examples of unsecured loans.

How to get a loan

Now you know what loans are, let’s cover how to get one. 

1. Work on your credit score. A good credit score increases your chances of getting a low interest rate on your loan. Put some credit-improving practices in place before your application (like paying credit card bills on time and refraining from closing accounts). 

2. Decide what type of loan you need. Planning to buy a new car? A house? Sending your child to college? What you plan to purchase informs the type of loan you need.

3. Review different lenders. Research financial institutions and shop around. Lenders may offer different interest rates and loan terms.

4. Gather documentation and apply. Each type of loan requires different documentation. For example, mortgage and auto loans require proof of employment. Student loans require proof of enrollment. Prepping your docs ahead of time will lock in a smooth application process.

5. Get approved and make monthly payments. Once the lender approves your loan, you’re ready to sign the agreement and begin making payments. 

Invest in your family’s future

Loans? Check. You’re ready to make bigger money moves — for even bigger life moments. That’s college, retirement, and more. Learn more about Greenlight’s parent offerings to unlock wealth building through saving, investing, and compound growth. Money milestones, here you come!