What is a loan?
Key takeaways
04 · ideas- A loan is money borrowed that must be repaid with interest
- Secured loans (lower rates) require collateral; unsecured don't
- At 25% APR, $10,000 costs $18,000+ to repay over 5 years
- Always compare APR — not just the monthly payment
Basic level
The essentials · 1 min
A loan is money you borrow with a promise to repay it — plus interest — over an agreed period.
The three parts of every loan:- Principal — the amount you borrow
- Interest — the fee the lender charges (a percentage of what you owe)
- Term — how long you have to repay
- Monthly payment: $313
- Total repaid: $11,268
- Interest paid: $1,268
- Secured: backed by something you own (home, car). Lower rates because the lender can take the collateral if you don't pay.
- Unsecured: backed only by your promise to pay. Higher rates because the lender has no fallback.
- Mortgage (home purchase) — secured, 6–8%
- Auto loan — secured, 6–12%
- Personal loan — unsecured, 10–20%
- Credit card — unsecured revolving, 18–29%
Intermediate level
How it applies · 2 min
How the same loan amount costs very different amounts
The rate and term dramatically change what you actually pay:
| Loan | Rate | Term | Monthly | Total cost | Interest paid |
|---|---|---|---|---|---|
| $10,000 | 5% | 3 yr | $299 | $10,769 | $769 |
| $10,000 | 10% | 3 yr | $323 | $11,616 | $1,616 |
| $10,000 | 20% | 3 yr | $372 | $13,392 | $3,392 |
| $10,000 | 10% | 5 yr | $212 | $12,748 | $2,748 |
| $10,000 | 10% | 7 yr | $166 | $13,898 | $3,898 |
The lower monthly payment trap: Longer terms lower your monthly payment but dramatically increase total interest. A 7-year loan at 10% costs 79% more in interest than a 3-year loan at the same rate.
What affects your loan rate
| Factor | Impact on rate | How to improve |
|---|---|---|
| Credit score 750+ | Best rates available | Pay bills on time for years |
| Credit score 650–749 | 1–3% higher | Reduce credit card balances |
| Credit score below 650 | 3–8% higher | Dispute errors, reduce debt |
| Debt-to-income > 43% | May be denied | Pay down existing debt first |
| Down payment (secured) | 1–2% lower with 20%+ down | Save before borrowing |
| Loan term | Shorter = lower rate | Choose shortest term you can afford |
APR vs. interest rate
Always compare APR, not just the stated rate.
A bank might advertise "8% interest" but charge $500 in origination fees on a $10,000 loan:- Stated rate: 8%
- APR (including $500 fee): 12.1%
The APR reveals the true annual cost. It's the only honest comparison between offers.
Advanced level
The math, step by step · 1 min
The loan amortization formula
Monthly payment M for principal P, monthly rate r = r_{annual}/12, n payments:
This is why early payments are mostly interest: the outstanding balance is highest at the start.
The true cost of consumer debt
The effective cost of financing a $30,000 car at 12% for 72 months vs. paying cash:- Monthly payment: $592
- Total paid: $42,624
- Interest cost: $12,624
But if that $30,000 had been invested at 8% for 6 years instead: $47,612. The opportunity cost of the financed car is $12,624 (interest) + $17,612 (foregone investment gains) = $30,236 — equal to the car's purchase price.
This framework — comparing borrowing cost to investment opportunity cost — is the core of all personal finance optimization.