Loan Terms to Know Before You Borrow
It's important to understand the language your lender is using before you sign on the dotted line.
Loans provide borrowers with the ability to achieve the American dream, making it possible to own a home and automobile and take care of other major life expenses. However, many people use loans without fully understanding what they are committing to.
Because bank loans are generally for large sums of money, it's extremely important that the borrower has a firm grasp on what is required to pay the loan back, how much they will actually have to pay, and how long it will take to do so. There are quite a few things you should know before signing on the dotted line.
Understand the terms your banker is using.
It's critical to understand the terms your banker is using once the loan conversation starts. Here are just a few of the terms clients may encounter when applying for a loan:
- Term Loan: A loan in which the amount is amortized over a specified term with fixed monthly payments.
- Revolving Line of Credit: Open-ended line of credit with no specified maturity date. Payments vary based on outstanding balance.
- Risk-Based Pricing: Interest rates that are tiered based on the borrower’s FICO score.
- LTV: (Loan-to-Value) – The ratio of the principal balance of a mortgage loan to the value of the securing property, as determined by the purchase price or appraised value, whichever is less.
- DTI: (Debt-to-Income Ratio) – An applicant’s total monthly payments (including the new loan payment) divided by total gross monthly income.
- Liquidity: Assets that are available for quick liquidation to cash.
- Floor Rate: The lowest a rate can adjust to on an adjustable-rate loan.
- Ceiling Rate: The maximum a rate can adjust to on an adjustable-rate loan.
- Third Party Costs: Outside costs incurred for a loan, such as appraisal costs, title company fees, recording fees and property searches.
You’ll probably encounter many more confusing terms and acronyms, but don’t be embarrassed to ask for clarification of anything you’re unsure of. An important part of your lender’s job is to make sure you fully understand what you’re signing.
Understand the difference between interest rate and APR.
Make sure you understand the difference between an interest rate and an APR. An interest rate is simply the rate charged for borrowing the principal loan amount. The APR (Annual Percentage Rate) includes the interest rate as well as fees, discount points, and other costs. An interest rate can be variable or fixed, depending on the loan, but both the interest rate and APR will be represented as a percentage.
Credit Karma has a good resource1 that gets into the finer details to help you better understand the difference between interest rate and APR.
Understand the difference between fixed-rate and adjustable-rate loans.
In a fixed-rate loan or mortgage, the interest rate is determined at the time the loan is set up, and doesn’t change over the course of the loan. For example, in a 30-year, fixed-rate mortgage, the rate set up when the mortgage is originated stays the same for the entire 30 years.
In an adjustable-rate loan or mortgage, the rate adjusts according to market conditions. Some are fixed for a set period of time and then adjust annually according to the Prime Rate or another index stated in the credit agreement or promissory note. However, there are many different variations of these loan products, so if you’re applying for an adjustable-rate loan, it’s important to know the specific terms you’re being offered.
Understand the difference between a mortgage, a home equity loan and a home equity credit line.
Simply put, a mortgage is a loan that is used to purchase a property. The house you buy acts as collateral in exchange for the money you are borrowing to buy the house.
A home equity loan lets you borrow a lump sum from a lender, using the equity in your home as collateral. Generally, you will pay back this loan in equal monthly payments with a fixed interest rate.
With a home equity credit line, you can borrow or draw money multiple times from an available maximum amount, again using your home as collateral. These usually have adjustable interest rates.
Both home equity loans and lines of credit are often used for home improvements that add value to the property, but they can also be used to pay for emergency expenses, high-interest debt consolidation, or other uses. (Click here for an article about the new tax ramifications of using home equity loans for purposes other than home improvements.)
Understand the total cost of the loan.
Most importantly, understand what the total cost of borrowing the money will be. That means knowing the principal amount, as well as the interest rate and APR. Make sure the total is spelled out for you so there is no misunderstanding about how much you will end up paying.
Nevada State Bank provides this enhanced loan calculator to help you estimate costs.
Make sure you read the terms of the loan carefully.
Financial documents can be daunting, but it's important that you closely read the terms of your loan before signing on the dotted line. Pay special attention to any penalties and fees, such as prepayment penalties and late fees.
Prepare yourself ahead of time by researching loans and gaining a general understanding of all associated terms and language. The better you understand all of this, the less likely it is that you’ll be confused when you visit your lender. If there is anything you don't completely understand, don't hesitate to ask your lender questions, and don’t sign any documents until things are 100 percent clear.
Educating yourself about loan terms can help you make better, more informed decisions about borrowing money.
The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice. Any views expressed in this article may not necessarily be those of Nevada State Bank, a division of ZB, N.A. Member FDIC