What Is a Loan, How Does It Work, Types, and Tips on Getting One

By 

Julia Kagan

Updated May 20, 2025

Reviewed by 

Erika Rasure

Fact checked by 

Diane Costagliola

Definition

A loan refers to a type of credit vehicle in which a sum of money is lent to another party in exchange for future repayment of the principal amount, generally with interest.

What Is a Loan?

A loan is a form of credit where a specific amount of money is given to someone with the agreement that it will be paid back later. In many cases, the lender also adds interest or finance charges to the principal value, which the borrower must repay in addition to the principal balance.

Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms, including secured, unsecured, commercial, and personal loans.

Key Takeaways

• A loan is when money is given to another party in exchange for repayment of the loan principal amount plus interest.
• Lenders will consider a prospective borrower’s income, credit score, and debt levels before deciding to offer them a loan.
• A loan may be secured by collateral, such as a mortgage, or it may be unsecured, such as a credit card.
• Revolving loans or lines can be spent, repaid, and spent again, while term loans are fixed-rate, fixed-payment loans.
• Lenders may charge higher interest rates to risky borrowers.

Understanding Loans

A loan is a form of debt incurred by an individual or other entity. The lender—usually a corporation, financial institution, or government—advances a sum of money to the borrower. In return, the borrower agrees to a certain set of terms, including any finance charges, interest, repayment date, and other conditions.

In some cases, the lender may require collateral to secure the loan and ensure repayment. Loans may also take the form of bonds and certificates of deposit (CDs). It is also possible to take a loan from a 401(k) account.

The Loan Process

Here’s how the loan process works: When someone needs money, they apply for a loan from a bank, corporation, government, or other entity. The borrower may be required to provide specific details such as the reason for the loan, their financial history, Social Security number (SSN), and other information. The lender reviews this information as well as a person’s debt-to-income (DTI) ratio, to determine if the loan can be paid back.1

Based on the applicant’s creditworthiness, the lender either denies or approves the application. The lender must provide a reason should the loan application be denied. If the application is approved, both parties sign a contract that outlines the details of the agreement. The lender advances the proceeds of the loan, after which the borrower must repay the amount, including any additional charges, such as interest.

The terms of a loan are agreed to by each party before any money or property changes hands or is disbursed. If the lender requires collateral, the lender outlines this in the loan documents. Most loans also have provisions regarding the maximum amount of interest, in addition to other covenants, such as the length of time before repayment is required.

Why Are Loans Used?

Loans are advanced for a number of reasons, including major purchases, investing, renovations, debt consolidation, and business ventures. Loans also help existing companies expand their operations. Loans allow for growth in the overall money supply in an economy and open up competition by lending to new businesses.

The interest and fees from loans are a primary source of revenue for many banks, as well as some retailers through the use of credit facilities and credit cards.

Components of a Loan

There are several important terms that determine the size of a loan and how quickly the borrower can pay it back:

• Principal: This is the original amount of money that is being borrowed.
• Loan term: The amount of time that the borrower has to repay the loan.
• Interest rate: The rate at which the amount of money owed increases, usually expressed in terms of an annual percentage rate (APR).
• Loan payments: The amount of money that must be paid every month or week in order to satisfy the terms of the loan. Based on the principal, loan term, and interest rate, this can be determined from an amortization table.

In addition, the lender may also tack on additional fees, such as an origination fee, a servicing fee, or late payment fees. For larger loans, they may also require collateral, such as real estate or a vehicle. If the borrower defaults on the loan, these assets may be seized to pay off the remaining debt.2

Tips on Getting a Loan

In order to qualify for a loan, prospective borrowers need to show that they have the ability and financial discipline to repay the lender. There are several factors that lenders consider when deciding if a particular borrower is worth the risk:

• Income: For larger loans, lenders may require a certain income threshold, thereby ensuring that the borrower will have no trouble making payments. They may also require several years of stable employment, especially in the case of home mortgages.
• Credit score: A credit score is a numerical representation of a person’s creditworthiness, based on their history of borrowing and repayment. Missed payments and bankruptcies can cause serious damage to a person’s credit score.3
• Debt-to-income ratio: In addition to one’s income, lenders also check the borrower’s credit history to determine how many active loans they have at the same time. A high level of debt indicates that the borrower may have difficulty repaying their debts.4

In order to increase the chance of qualifying for a loan, it is important to demonstrate that you can use debt responsibly. Pay off your loans and credit cards promptly and avoid taking on any unnecessary debt. This will also qualify you for lower interest rates.

It is still possible to qualify for loans if you have a lot of debt or a poor credit score, but these will likely come with a higher interest rate. Since these loans are much more expensive in the long run, you are much better off trying to improve your credit scores and debt-to-income ratio.

Relationship Between Interest Rates and Loans

Interest rates have a significant effect on loans and the ultimate cost to the borrower. Loans with higher interest rates have higher monthly payments—or take longer to pay off—than loans with lower interest rates. For example, if a person borrows $5,000 on a five-year installment or term loan with a 4.5% interest rate, they face a monthly payment of $93.22 for the following five years. In contrast, if the interest rate is 9%, the payments climb to $103.79.

Important

Higher interest rates come with higher monthly payments, meaning they take longer to pay off than loans with lower rates.

Similarly, if a person owes $10,000 on a credit card with a 6% interest rate and they pay $200 each month, it will take them 58 months, or nearly five years, to pay off the balance. With a 20% interest rate, the same balance, and the same $200 monthly payments, it will take 108 months, or nine years, to pay off the card.

Simple vs. Compound Interest