Explained: The Concept Of Loan Repayment
Your history of debt repayment is one of the most critical factors for determining your credit score. The better your habits, the more successfully you’ll be able to secure financing at favorable terms.
Therefore, it’s good to know precisely how loans are paid off and the variables that play a role in a repayment plan.
Keep reading to discover the definition of loan repayment.
How Does A Loan Work?
When you borrow money from an institutional lender, family member, or friend, it’s called a loan. You receive a lump sum of money, and you agree to pay back this amount.
There are two types of lending:
- Secured: You pledge an asset as collateral that can be forfeited if you fail to repay
- Unsecured: No collateral is required to borrow a sum
Keep in mind that unsecured lending products are riskier for lenders, so the interest charged tends to be higher.
Here are some other important terms to familiarize yourself with:
- Principal: The original amount of money that you borrowed and agreed to repay
- Term: The specific duration of time you agree to repay the borrowed amount
- Revolving debt: This is an open-ended lending product where you can borrow up to the approved limit, repay (not in regular installments), and draw more funds any number of times while credit is available. A typical example of revolving consumer debt is a credit card
- A traditional loan: Once you arrive at the end of the term and have made all the payments, the account is closed. If you need more money, you’ll need to apply for a new lending product
Lenders might also charge additional costs, such as:
- Application fees
- Origination fees (mortgages)
- Processing fees
- Late fees
- Annual fees (for credit cards)
- Prepayment fees
What Factors Influence Your Debt Repayment Plan?
Your repayment plan depends on the type of financing. Some lending products, such as student loans, offer a menu of debt repayment options, including deferment periods depending on the borrower’s preferences.
Typically, you’ll pay back a personal loan in fixed monthly amounts. The interest rate depends on your credit score. If you have good or excellent credit, your monthly payment will be lower because less interest accumulates on your borrowed principal amount.
Before approving your application, the lender checks your financial history. If you demonstrate better reliability, you’re considered a low-risk borrower. The lender may offer you a lower interest rate, and you’ll potentially be eligible to borrow more considerable sums.
How Is Interest Calculated?
- Simple: Simple interest is calculated only on the original sum of money that you borrowed. The formula is the principal multiplied by the interest rate and the number of borrowing periods
- Compound: The rate for most debt repayment is compounded, either daily, monthly, or yearly. Compounded interest accumulates
- Amortized: As you continue paying back your loan, the portion going toward the principal increases, resulting in a corresponding decrease in the interest paid in each installment
- Fixed: The rate charged is set when you sign the official documents, and it doesn’t change over the lending product’s tenure
- Variable: The rate can go up or down over the lending product’s duration depending on the prevailing market rate
How Are Loans Paid Off?
In exchange for the financing, you agree to pay back the loan over a specific term. The most common repayment plans are as follows:
Credit cards:
- Type of revolving debt
- You must pay the minimum due each month
- Interest accumulates on outstanding balances
- You can pay the balance in full and avoid interest
Short-term consumer loans:
- Duration is from a few months to a few years
- Interest is fixed over the entire tenure
- You make level monthly payments
Auto loans:
- Monthly payments cover the principal and interest
- Usually, interest is fixed
- Terms usually last between three and five years but can be longer
Long-term loans, such as mortgages:
- Monthly payments cover principal and interest
- Some long-term debt repayment comes with variable interest rates, and others involve fixed rates
- Terms usually last five to 30 years
What Happens If You Can't Pay Back Your Loan?
There are many reasons you might not make your regular payments like if you lose your job or experience a health emergency.
No matter the reason, if you fail to make the payments, your loan can go into default. Depending on the type of financing and the lender, this could happen after missing only one payment. Most creditors will wait until you miss a few payments before sending your account to collections.
If your failure to pay continues, you risk wage garnishment or a bank levy. If financing was secured by collateral such as your home or car, the lender has the right to seize the property and sell it to recoup their losses.
Even if your unpaid balance doesn’t reach the collections stage, you could still ruin your credit. This is because your payment history makes up 35% of your credit score. Thus, the impact on your score is significant. Moreover, defaults and collections can stay on your report for seven to 10 years.
Read more: What To Do When You Can’t Make A Loan Repayment
The Bottom Line
Before you obtain any financing, it’s essential to understand what repayment means in the context of different lending products that involve varying debt repayment plans. This valuable information can help determine how much you can borrow and if you can afford to make the payments.
If you’re unable to meet your obligations, you should contact the lender immediately. In most cases, they’ll be happy to agree to a plan to help you gradually repay the debt.
