How Loans Work and What to Know Before You Borrow

Many will turn to a loan in order when their savings or personal finances won’t allow them to afford something like a purchase, or to pay down debt they carry. While loans can provide benefits, it’s important to understand some basics, because they can become an issue as well.

Understanding how loans work and how lenders make their money is key to protecting yourself and avoiding large amounts of debt, unforeseen fees or high interest rates. Before you borrow it’s wise to familiarize yourself with some of the language you’ll likely come across when comparing your options in Canada.

Loan Language

Principal

When you borrow, the principal is the amount you agreed to borrow and pay back to the lender. It is the amount borrowed and does not include interest or fees. It’s important that you are completely aware of costs and know what you can afford to borrow before taking a loan. You should also be sure to read the agreement and understand all aspects of a loan before signing.

Interest Rate

This is the amount the lender charges for borrowing, which is usually a percentage of the loan.

The percentage amount is typically based on your credit score by the lender and lower rates are usually offered to creditworthy borrowers. Those with a poor credit history are more likely to qualify for bad credit personal loans with some suggesting guaranteed approval. This is a misleading tactic with some lenders using this to attract applications.

Term

This is how you repay the loan, which is usually setup as monthly payments (or installments) of an agreed amount within a specific timeframe. Sometimes it can be challenging when choosing the term length, since a shorter term means paying less interest, but a longer term has lower monthly payments. Depending on the terms of the agreement, early repayment can result in penalty fees, and late payments are likely to damage your credit.

Loan Costs

When you are considering a personal loan or installment loan, you will be expected to pay back the principal amount borrowed along with interest, which is usually spread over the term of the loan as monthly scheduled payments. While you can get a loan of the same principal from a variety of lenders, it’s the interest rates, terms and any other fees that determine what you might repay each month. It is worth noting that payday loans can be another choice when there are no other options for borrowing, but it is an expensive way to borrow.

Loan Fees

While not every loan includes the following fees, many can include some, and understanding what they are and how they work before you sign is just good money management and personal finance smarts. The cost of borrowing can be tricky to follow, especially with fees attached. The interest rate tells part of the story, where the APR (annualized percent rate) give you a better idea of the cost for borrowing.

Application Fee – some lenders charge this to process of approving loan request

Processing Fee – not unlike the application fee, this is associated with administering a loan.

Origination Fee – this helps cover the costs of credit check fees, processing, underwriting, and funding by lenders. They are generally between 1% to 8% and depend on the amount borrowed and your credit score.

Brokerage Fee – this might be charged when using a service that connects you to a direct lender and a flat fee. Not all non direct lenders charge this fee.

Closing Fees – it might be rolled into monthly costs or take from the amount funded and typically no more than a couple hundred dollars. This covers things like a brokerage fee, application costs or a lender’s commission.

Commitment Fee – for a loan that won’t be funded immediately some lenders might charge this to make up for interest they could be charging. It can be either a fixed percentage or a flat fee. You can avoid it entirely by either applying when ready or accepting funding immediately upon acceptance of application.

Document preparation fee – some lenders will charge this to offset costs associated with processing your loan. It’s often possible to find providers that don’t charge this fee.

IBV – Instant bank verification (or IBV for short) is when you connect your bank account. This allows lenders to verify your identity and to review your account for income, debt and similar.

Paper copy fee – sometimes online lenders will charge a fee if the borrower requests a hard copy (printed) of the loan agreement for themselves.

Underwriting fee – these are to cover costs of assessing the level of risk the lender may take on with specific borrowers. Loan underwriters are the people that review and assess this.

Prepayment Fee – with some lenders, paying off your loan early can cost you too.

There are also other potential fees if late with payments or related issues such as a late payment fee, electronic payment processing fee, payment convenience fee or non sufficient funds fees.

When it comes to funding, you can get loans by e-transfer or you can have the directly deposited to your bank account.

Sometimes there can be other ongoing administration fees that go by different names like loan services fee or online connection fee. These miscellaneous fees are about helping the lender recoup costs associated with administering the loan. It’s important to carefully read your loan agreement, including fee structures and amortization tables to determine whether such fees are within your loan terms.