The Basics: What Is a Loan?
A loan is a formal agreement in which a lender provides you with a sum of money (the principal) in exchange for your promise to repay it, plus interest and any applicable fees, over an agreed period of time (the term).
Most consumer loans are installment loans: you repay a fixed amount each month (the monthly payment) until the loan is paid off. Each payment covers accrued interest for that period plus a portion of the principal.
How Interest Is Calculated
Interest is the cost of borrowing money. It is expressed as an annual rate, the interest rate (or more comprehensively, the APR, which includes fees). There are two accrual methods:
- Simple interest: Calculated on the outstanding principal only. As you repay principal, the interest owed each period decreases. Most personal loans use simple interest.
- Compound interest: Calculated on principal plus previously accrued interest. More common in savings accounts and some credit products. Can significantly increase the cost of debt if not actively repaid.
Amortization: How Payments Are Split
For most installment loans, your monthly payment stays the same, but the split between interest and principal changes over time. This is called amortization:
- Early payments: more goes to interest (because the balance is high)
- Later payments: more goes to principal (because the balance has fallen)
- Final payment: the remaining balance is cleared, and the loan is closed
Amortization Example: $10,000 at 10% APR over 36 Months
| Payment | Monthly Payment | To Interest | To Principal | Balance Remaining |
|---|---|---|---|---|
| Month 1 | $322.67 | $83.33 | $239.34 | $9,760.66 |
| Month 6 | $322.67 | $74.73 | $247.94 | $8,736.61 |
| Month 12 | $322.67 | $64.23 | $258.44 | $7,440.14 |
| Month 18 | $322.67 | $53.17 | $269.50 | $6,077.46 |
| Month 24 | $322.67 | $41.52 | $281.15 | $4,643.55 |
| Month 36 | $322.67 | $2.68 | $320.00 | $0.00 |
Illustrative figures only. Actual payments depend on the lender's specific terms and calculation method.
The Full Loan Lifecycle
Stage 1: Application
You submit a loan application, providing income details, employment information, and consent for a credit check. The lender performs a hard inquiry on your credit report, this temporarily lowers your credit score by a small amount (typically 5 points or fewer) and remains on your report for two years.
Stage 2: Underwriting and Decision
The lender assesses your application against their criteria: credit score, debt-to-income ratio (DTI), employment stability, and loan amount. They may approve, decline, counter with a different amount or rate, or request additional documentation.
Stage 3: Offer and Acceptance
If approved, you receive a loan offer specifying the principal, APR, monthly payment, term, and any fees. Review this carefully before accepting. You are under no obligation to accept an offer, and accepting creates a binding agreement once the funds are disbursed.
Stage 4: Funding
Once you accept, funds are deposited to your bank account, typically within 1–5 business days for personal loans, though some online lenders fund the same or next business day.
Stage 5: Repayment
Monthly payments begin, usually 30 days after funding. Most lenders accept autopay from a bank account, often offering a small APR discount (typically 0.25%) for setting it up. Making payments on time is the single largest factor in your credit score (35% of the FICO calculation).
Stage 6: Early Repayment
Most personal loans allow early repayment without penalty. Paying off the loan early reduces the total interest you pay, because interest accrues on the outstanding balance. Check whether your lender charges a prepayment penalty before overpaying.
Common Loan Fees
| Fee | What It Is | Typical Range |
|---|---|---|
| Origination fee | Charged for processing the loan, often deducted from proceeds | 1%–8% of principal |
| Late payment fee | Charged when a payment is missed or late | $15–$40 or 5% of payment |
| Prepayment penalty | Charged for paying the loan off early (less common) | 1%–3% of outstanding balance |
| Returned payment fee | Charged if a payment bounces (insufficient funds) | $15–$30 |
Secured vs. Unsecured Loans
Loans are either secured (backed by an asset, your home, vehicle, or savings) or unsecured (no collateral required). Secured loans typically offer lower rates but carry the risk of asset loss if you default. See our guide to secured vs. unsecured loans for a full comparison.