If you’re looking to buy a home, a car, or make any other large expenditure, you should be prepared for the possibility of a loan. This simple financial arrangement involves a borrower, you, who will be temporarily given resources from a lender. The expectation from the lender isn’t just that they’ll be paid back, but usually, that they’ll be paid back with interest. In the loan agreement, these original amounts borrowed (the principal) plus any additional fees (interest) over time will be outlined. Sometimes, a borrower will have to put up collateral in the principal as an added measure.
Before you apply for a loan you need to yourself and determine how much loan can I qualify for? This article will look at reasons for getting a loan, types of loans, reasons for getting them and how to calculate your borrowing power.
Why do I need a loan?
- Major purchases – Loans enable individuals or businesses to buy things that they might not be able to afford upfront, like a car, a home, an expensive item, or any equipment.
- Business growth – Businesses will oftentimes rely on loans to finance their expansion, invest in any new projects, or manage cash flow during slower periods.
- Education – You’ve likely heard of them before, and maybe you have a few for yourself; student loans help finance the education of those who wouldn’t likely be able to afford them.
- Debt consolidation – Loans can be used to consolidate multiple debts into a single, more manageable payment.
While loans offer financial flexibility, it’s crucial to use them responsibly. Borrowing money carries the risk of debt accumulation if not managed carefully. It’s important to consider the interest rate, repayment terms, and overall affordability before taking on a loan.
5 types of loans
1. Personal loans
Personal loans are versatile financial tools that can fund renovations or additions to your home, combine multiple debts into a single, lower-interest loan, cover unexpected medical costs, or pay for large purchases like furniture or appliances.
Personal loans are typically unsecured, meaning they don’t require any collateral. However, interest rates and terms can vary depending on factors like credit score and income, and can sometimes be higher because of the lack of collateral.
2. Auto loans
Auto loans are designed specifically to finance the purchase of a car, motorcycle, truck, or other vehicle. They are typically secured loans, meaning the vehicle itself serves as collateral. Most auto loans offer fixed interest rates, and auto loan terms can range from three to seven years. As is usually the case with interest across the board, shorter terms generally result in lower rates.
3. Student loans
Student loans serve as financial aid to help students cover the high price of education. Federal student loans are offered by the U.S. government and often have more favorable terms, such as fixed interest rates and income-driven repayment plans. Private loans offered by banks, credit unions, and other private lenders typically have higher interest rates and fewer repayment options. Sometimes, borrowers will have to take out both.
4. Mortgage loans
Mortgage loans are used to purchase real estate – most commonly, homes. They are secured loans, with the property being purchased serving as collateral. These mortgages have a fixed interest rate for the entire loan term, or an interest rate that adjusts periodically based on a specific index.
5. Home equity loans
Home equity loans allow homeowners to borrow against the equity they have built up in their homes in order to finance further recommendations. That means that if the current market value of the home is more than the outstanding mortgage balance, you can borrow more money in the amount of the difference. Home equity loans typically have a fixed interest rate, making it easier to budget for monthly payments – however, they can be dangerous, as if you default on the loan, the lender can foreclose on your home.
How to calculate your borrowing power
If you’re looking at one of these loans for yourself, borrowing power depends on your income, debt, and credit score. Lenders often use a something called a debt-to-income (DTI) ratio to assess your ability to repay a loan. They’ll look at how much debt you have and how much your income is and use an equation to determine how much power you have. A lower DTI ratio, typically 35% gap between your debt and income (or less), indicates a higher borrowing power.
If you’d like to know your borrowing power before you apply for a loan, you don’t need to be a math whiz – there are plenty of borrowing power calculators online. You can also consult your credit report, which will assign you a number between 300-850. The higher the number, the more freedom you’ll have in your borrowing power. And the lower the number, the more you need to work on building credit in the future.