Loans: Investing Essentials

The modern economy runs on borrowed money. Individuals to businesses and even governments use loans to balance out their spending with their income. 

The average American will borrow money several times in his or her lifetime to finance everything from cars to college expenses. Understanding what these loans are, and how they work, is crucial to understanding your personal finances.

What are loans?

Put simply, a loan is a way to borrow money that will be repaid later. Loans allow you to buy something you cannot afford with savings, and pay for it with regular monthly payments.

Here are some example purchases and their respective costs if paid for with a loan.

Take into consideration that the amount you repay on a loan will always be greater than the amount you borrowed. The difference is due to interest -- the money you have to pay to reward the lender for the risk of the loan, and the time it takes to repay the lender.

In the example above, the payments on a new home would add up to roughly $499,000, nearly twice the purchase price of the home. The amount of interest that you pay is directly related to the interest rate, and the length of the loan. 

What is the history of loans?

Since most people cannot afford to pay the upfront cost of a home, car purchase, or college education out of pocket, loans provide a vital way for the average person to make these big purchases.

Loans date back to the beginning of human history. The first lenders operated much like pawn shops we know today, requiring the borrower to provide collateral upon which a loan could be drawn. The collateral served as protection for the lender, as he or she could sell it to recoup some or all of the loan amount unpaid by the borrower.

This system works well for small loans. Today, pawnbrokers provide loans that average about $125 for 30 days, according to a national trade association.

With increasing desires for a better standard of living, new methods of lending have taken over. The federal government played an important role in the growth of available loan products. The National Housing Act of 1934 laid the groundwork for average Americans to buy a home with 30-year mortgages. The Department of Education provides the majority of student loan financing.

Technological developments helped usher in credit cards and car loans as widely available sources of funding for smaller, but still significant, purchases.

How many loans are there?

Loans can be categorized into two basic types: secured and unsecured. A secured loan is one which is backed by collateral -- a home or a car, for instance.

An unsecured loan is one which is backed only by the borrower's ability and willingness to repay -- a credit card is a good example.

Generally, secured loans offer much longer repayment terms and lower interest rates than unsecured loans. Secured loans are backed by some form of collateral, which gives the lender more safety. Less risk for the lender means lower interest rates for the borrower.

The table below documents different loan types, their terms, and their relative interest rates.

*Student loans are secured by the borrower's income. If unpaid, lenders, through the courts, can garnish a borrower's wages to pay for unpaid student loan balances.

The Federal Reserve Bank of New York keeps a running tally of existing loans in the U.S. Financial System. As of its latest report, mortgages made up the majority of all loans outstanding. Student loans were second, and auto loans were third.

Why use a loan?

A loan is used best when it will help you make a necessary purchase today that you couldn't otherwise afford. But loans should be used responsibly. A small mortgage loan to purchase a home makes economic sense, because the alternative -- renting -- can be more costly over time.

However, frivolous borrowing and overuse of lending is a quick way to fall into financial trouble. Buying an unnecessarily expensive new car isn't a productive use of a loan. Likewise, paying 20% interest on a credit card to afford a new Smart TV probably isn't a justifiable financial move.

The key to responsible borrowing is finding a balance between your desire to make a purchase now vs. the total cost of a loan over time. It's not rocket science, but careful thought can keep you out of a common financial trap.