What is a loan?

A loan is someone else's money, handed to you now, in exchange for a promise: you will pay it all back, plus extra, over time. The extra is interest, and it is the price of the deal. Every loan you will ever see, from a $500 phone plan to a $700,000 mortgage, is that same deal wearing different clothes.

The words on every loan contract

• Principal: the amount you actually borrow.
• Interest rate: the price of borrowing, quoted as a percentage per year.
• Term: how long you have to pay it all back.
• Repayments: the regular amounts, usually monthly, that chip away at the debt.
• Security: something the lender can take and sell if you stop paying, like the car or house the loan bought.

A loan with security is called a secured loan, and because the lender carries less risk, the interest rate is usually lower. An unsecured loan has nothing behind it except your promise, so the rate is higher. This one idea explains most of the difference between a 6% car loan and a 20% credit card.

Why interest exists at all

So why does the lender get to charge extra in the first place? Three reasons sit underneath every interest rate. The first is time, because money in hand today is worth more than the same money in a year, since you could be using it now. The second is risk, because there is always some chance you do not pay it all back, and the lender prices that chance in. The third is inflation, because prices tend to drift up over time, so the dollars repaid later buy a little less than the dollars lent today. Interest is what covers all three, which is why even the safest, most secure loan is never free.

Here is the idea at its simplest. Imagine you borrow $1,000 at an illustrative 10% a year and agree to pay it back in one lump at the end of the year. When the year is up you hand back $1,100: the $1,000 you borrowed, plus $100 of rent on it. Hold the money for two years instead of one and the rent keeps running, so it costs you more. Real loans are tidier than this, because you usually chip the balance down month by month rather than holding the whole amount for a year, and the later lessons show exactly how that changes the sum. But the shape never changes: you pay for the money for as long as you hold it.

What a loan really costs

The sticker on a loan is the interest rate, but the real cost is the total of everything you pay: interest, plus establishment fees, monthly account fees and any charges along the way. Borrow $10,000 and you might repay $12,000 or $15,000 depending on the rate, the fees and the term. The question that cuts through every loan advertisement is simple: how many dollars will leave my account, in total, before this is over?

Where you will meet your first loan

Most people meet borrowing long before they ever sit across a desk from a bank. A phone bought on a 24 month plan is a loan, with the handset as the thing you are slowly paying off. A buy now pay later account that splits a $200 pair of shoes into four payments is a loan too, even when it calls itself something friendlier. The moment money you have not earned yet is paying for something today, you are borrowing, and the same two questions apply: what is the total, and what is it costing me to hold the money.

A common trap is to hear the words interest free and assume the credit is free. It rarely is. Buy now pay later accounts often charge no interest but make their money from late fees and account fees, so a missed payment can quietly add a fee, and those fees stack up each time until they rival the interest a plain loan would have charged. Interest free tells you how one part of the price is set. It does not tell you the deal is free.

Both sides of the desk

It helps to remember that you already know how lending works, because your savings account is you being the lender. You hand the bank your money, and it pays you interest for the privilege. A loan is the same arrangement reversed, which is why the interest on a loan is always higher than the interest on savings. The gap between the two is how banks earn a living.

Every loan you meet from here is a version of this one deal wearing different clothes. The next lesson looks at why people take the deal at all, which reasons hold up and which are traps, and the interest lesson later pulls apart exactly how the price is worked out.