How Do Loans Work?

Loans have probably been around for as long as money has. In fact, there’s evidence that lending existed thousands of years ago in ancient Mesopotamia. Though the specifics of lending have changed since then, the concept remains similar.

A loan is money that’s been borrowed and needs to be paid back, typically with interest. Interest is what a lender charges the borrower for borrowing money; it’s calculated as a percentage of the loan, usually as an annual rate. Loans are often offered by banks, credit unions and online lenders.

To be approved for an unsecured loan, you need to demonstrate your creditworthiness and ability to pay back the amount you intend to borrow. These days, that means sharing information such as your credit history and credit score with the lender. There are also secured loans, which require you to put up assets as collateral.

Once you’re approved, the money is generally given up front in a lump sum by the lender. Then, you repay the loan in installments — with interest — over a predetermined amount of time called the loan term.

Understanding the costs of borrowing is the key to understanding how loans work. The principal is the amount you borrow from the lender, while the interest is the amount you pay the lender for borrowing the principal. The principal, interest and applicable fees determine how much you will pay over the life of the loan.

Lenders base your interest rate on information that is provided during the application process. Generally — all things equal — the higher your credit score, the lower the interest rate you’ll be approved for, and vice versa.

Interest payments are not the only costs associated with a loan. Sometimes there are fees, such as loan origination fees and late fees, which could affect your overall cost of borrowing or the amount of money you receive.

To get a true sense of the total cost of borrowing, check the loan’s APR, or annual percentage rate. This number reflects both the interest rate and other costs associated with the loan. The APR gives the total yearly cost of borrowing money as a percentage of the principal.

For example, say you need to borrow $8,000 to fix a leak in your bathroom. That $8,000 is the principal. If the interest rate is 15% (with no additional fees) and the loan term is three years, your monthly payment would come to $277.32 a month. Over the life of the loan, you would pay a total of $9,983.61, which includes repayment of the principal plus interest.

Different types of loans

Not all loans are the same. For example, a loan can be either secured or unsecured.

Unsecured loans are loans that do not require you to put up assets as collateral, such as your car or home, to qualify for the loan. Unsecured loans are issued based on an analysis of factors such as your creditworthiness and ability to pay.

Secured loans do require that you put up collateral to qualify for the loan. The collateral that you provide can be seized and sold by your lender if you default on your loan. This provides protection for your lender in case of default.

Loans also have several different uses:

Personal loans are loans lent to an individual, usually paid back with interest in fixed, monthly payments over a set term. If the personal loan is unsecured, it means it does not require you to put any of your possessions on the line to secure the loan.

Student loans are unsecured loans used solely to cover the costs of higher education. Both government and private lenders offer student loans. Federal student loans are generally associated with lower costs and an easier approval process compared to private loans. Private student loans take an applicant’s credit into consideration and require sufficient income. Students who don’t meet the criteria for a student loan will need someone, such as a parent, to cosign for the loan.

Mortgages are secured loans used for real estate purchases. These loans are secured by the property you are buying. If you fail to pay back the loan, you could lose your property to the lender.

Auto loans are another common type of secured loan. Similar to mortgages, auto loans are secured by the asset you are buying — in this case, a vehicle. Failing to pay back the loan could mean losing your vehicle.

How do personal loans work?

Personal loans typically offer some flexibility in how you use the funds.

A personal loan could provide you with the funds you need to finally start a home improvement project, cover emergency expenses, pay for a wedding or even consolidate your existing debt.

Surprisingly, the most common use for a personal loan is debt consolidation.

Debt consolidation is the process of combining your multiple outstanding debts into a single new debt. When you use a personal loan to consolidate your debt, you are essentially taking out and using the new loan to pay off your existing debt.

There are many advantages to this. First, simplicity. Rather than owing money to multiple creditors, you have just one loan to worry about. Also, if you’re consolidating credit card debt with a personal loan, the interest rate on the personal loan will typically be lower than the interest rate on your credit card.

Personal loans could have a much lower interest rate than what you’re currently paying with high-interest credit cards, especially if you have strong credit. Plus, consolidating debt with a personal loan could even improve your credit score.

How to get a loan

There’s a reason loans have been around for so long — they can be helpful in a variety of situations, benefiting both the borrower and the lender.

If you’re considering a loan, where do you start?

Applying for a loan can seem like a daunting process, but it doesn’t have to be complicated. If you want a walk-through of the loan-application and approval process, our article on How to Get a Loan can help.

Doing your research is the first step to a less stressful application process, so you’re off to a good start.

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This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this site were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of Goldman Sachs Group, Inc., Goldman Sachs Bank USA or any of their affiliates, subsidiaries or divisions.