A loan is when a lender (like a bank) gives a borrower (like you) money, with the expectation that the money will be repaid over a period of time, with interest.
The borrower also pays the lender more money on top of the loan amount, for the convenience of borrowing it in the first place.
That extra fee is called interest, and it’s how the lender makes money.
Otherwise, there wouldn’t be an incentive for the lender to do any lending.
There are a variety of loan types.
In Canada, three popular loan products are:
1. Personal Loan
A personal loan can make sense if you need a large sum of money all at once, especially for something that will make you more money down the line — like starting a business or doing a major renovation to create a rental suite in your house.
A lender will give you an amount of money that you’ll pay back in instalments — usually once a month, for a year or more (up to 10 years).
The lender will charge interest on the loan amount, meaning you’ll pay back the principal loan amount as well as interest charges.
2. Car Loan
If you want a new car but can’t afford to pay for it all at once, you’ll likely use a car loan.
An auto dealer or car financer will set you up with an agreement where you pay a small amount of the car’s price — called a down payment — at the beginning of the term.
Then, you’ll pay weekly or monthly instalments, a portion going to the principal and a portion to interest, that chip away at the car’s total price until it’s paid off.
3. RSP Loan
People commonly use retirement savings plan (RSP) loans to “catch up” on unused contribution room in their RSP.
Basically, money you put into an RSP can save you money on your tax bill.
If you don’t have enough money to max out the amount you can put into your RSP in a certain year, it can save you money in the long run to pay the interest on an RSP loan — which can be less than the amount you’ll save at tax time.
Make sure to do some research (and some math) before committing to an RSP loan. And think about whether it’s worth it to save some money at the expense of paying interest on a loan.
Revolving vs. Term Loans
A term loan has a fixed repayment schedule with instalments, which the borrower and lender agree upon.
There are consequences for the borrower if they don’t stick to the schedule.
A car loan is an example of a term loan.
The consequences for not keeping up with loan payments could be that the borrower loses their car to the lender.
A borrower can use a revolving loan up to a maximum limit they agree upon with the lender.
Once they pay that amount back, the total limit goes back up by the repaid amount (up to the maximum limit), and the borrower can use those funds again.
While that might sound complicated, you likely have one.
A credit card is the most popular type of revolving loan.
Fixed vs. Variable Rate Loans
A fixed rate loan will have the same interest rate for the duration of the loan.
This means the amount of interest charged throughout the term of the loan will always remain the same.
A 5-year fixed-rate mortgage term is a popular example of a fixed-rate loan where you can lock in an interest rate for a certain term.
As you might’ve guessed, a variable loan is the opposite.
These loans have interest rates that are tied to a broader indicator (such as the federal government’s key interest rate) and could fluctuate depending on changes in the market.
Many loans, like mortgages, student loans, and personal loans, often come with fixed and variable rate options.
While the stability of a fixed rate loan sounds appealing — especially with a large purchase like a house — it might make more sense to go with a variable rate in some scenarios.
That’s because the risk a borrower takes on with a variable rate loan means that lenders don’t usually charge as high of an interest rate.
In cases where borrowers expect that the broader indicator that their loan is tied to will go down over the course of their loan term, they would likely opt for variable rate loans.
Secured vs. Unsecured Loans
To get a secured loan, a borrower must offer up collateral — something valuable that the lender gets if the borrower “defaults,” or doesn’t pay back the loan.
Borrowers can usually get better interest rates with secured loans, and a higher amount to borrow.
You might’ve heard ads offering loans to homeowners with bad credit — this is how those lenders make money.
A mortgage is an example of a secured loan.
An unsecured loan is the opposite.
There’s no asset the borrower offers up as collateral, so there’s more risk for the lender, who has to make a judgment call about whether the borrower will be able to pay it back.
This usually means higher fees and more restrictions.
A student loan is an example of an unsecured loan.
Interest on Loans: Simple vs. Compound
Simple loan interest is calculated annually on the principal, i.e., the amount you initially borrowed.
Compound loan interest is added to the principal.
Every time compound interest is charged, it creates a new amount with which to calculate the next round of interest.
The interest can be charged daily, weekly, monthly or annually.
Compound interest is great for things like investments.
When you’re earning it, compound interest can snowball into a high number over a long period of time.
But that’s what makes it so dangerous for loans, when you have to pay it back.
For example, if you borrowed $10,000 over 10 years at 5% simple interest, you would have to pay back $15,000 in total.
The amount you would have to pay back on that same loan calculated with monthly compound interest is $16,470.09.
Frequently Asked Questions
- What is the difference between a loan and credit?
For a loan, a lender gives a borrower a set amount of money, and the borrower pays it back over time or all at once, plus interest.
Credit refers to an amount of a lender’s money that a lender lets a client spend — say, with a credit card — with the understanding that the client will pay it back on time. If the client doesn’t, they’ll be charged interest.
A “line of credit” is a loan that can be borrowed and paid off repeatedly without applying for a new loan each time. A credit card works similarly to a line of credit.
- Is financing a car the same as a loan?
Financing a car refers to securing an auto loan, which you pay back over a period of time. Financing is can be completed by the auto brand you are purchasing your car from, by an auto finance company or even a bank that offers auto loans.
You can also get a personal loan from a bank or other lender that’s different from the place you’re buying your car. Then you can use that amount to pay for the car, and pay the lender back in instalments.