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What Are Bank Loans and How Do They Work?

In this article

  1. What is a bank loan?
  2. How do bank loans work?
  3. FAQs
  4. A bank loan can help you reach your goals

Banks can be a great resource if you are looking for financing. Here are the basics of bank loans and how they work.

Katana Dumont • January 12, 2023

It takes money to make money, the saying goes. You will often need to borrow money for large purchases like a home or a car, or for goals like starting a business or getting your degree.

You can choose from many types of lenders, but one of the most common and trusted places to secure a loan is a bank.

What is a bank loan?

A bank loan is money borrowed with interest from a financial institution, like a bank or a credit union. Bank loans can be short-term or long-term, depending on the purpose of the loan.

Bank loans can be secured, meaning it’s attached to collateral. An example of a secured bank loan is a mortgage loan. If a borrower defaults on loan payments, the bank is legally allowed to possess the home (the collateral) to pay off the outstanding debt.

Bank loans can also be unsecured, meaning no collateral is attached to the loan. Unsecured loans tend to come with a higher interest rate because they are riskier for a lender than secured loans.

Types of bank loans

There are many bank loans available. Here are some of the most common types of bank loans:

  • Auto loan: These loans help finance a car purchase.
  • Personal line of credit: This type of financing allows you to withdraw money up to a certain limit. You can use the funds for just about anything.
  • Mortgage: Also known as a home loan, this type of loan helps borrowers finance a home.
  • Personal loan: With this type of loan, borrowers receive a lump sum of money upfront and make fixed monthly payments. The borrower can use that money to meet a variety of financial needs.
  • Student loan: These loans help cover education costs. If borrowing from a bank, this would be considered a private student loan.

Note: A personal line of credit and a personal loan ultimately work the same way. The biggest differences are the terms, such as the repayment periods and interest rates.

How do bank loans work?

When you apply for a bank loan, the bank will review your application, credit score, history, and income to determine how much money they will lend you and at what interest rate.

Applicant requirements

Some banks only offer loans to their existing customers. Others will accept loan applications from any borrower (existing customer or not). Check beforehand to make sure the bank can offer you a loan.

In some cases, it’ll be in your best interest to borrow from a bank in which you already have an account, especially if you’re in good standing with the bank. You may earn a lower annual percentage rate (APR) and other added perks, like a rate discount.

Building credit will help you apply for mortgages and other loans in the future.

Eligibility requirements

To qualify for a bank loan, you’ll need to meet the eligibility requirements listed by the bank or credit union to which you’re applying. Here are the main factors a bank will consider:

  • personal credit history
  • credit score
  • debt-to-income ratio
  • payment history

A bank needs to feel confident that you’ll be able to repay the loan.

Your credit score will play an especially huge part when applying for a bank loan, both for approval and to determine how much interest you’ll pay over the life of the loan. Every lender will have their own credit score requirements, but, in general, you can refer to the table below to help you determine your credit score eligibility for these types of loans.

Loan TypeCredit Score
Personal loan¹640 and above

760 and above for the lowest interest rates

Auto loan²660 and above

760 and above for the lowest interest

Mortgage³620 and above

760 and above for the lowest interest rates

Private student loan4650 and above

721 and above for the lowest interest rates

Pro tip: If your credit score falls more into the fair or poor range, you may be better off applying for a loan through a credit union or online financial institution. These lenders tend to have more lax credit score requirements, lower interest rates, and flexible repayment terms.

Application process

You’ll typically be able to apply online or in person for a bank loan. The application will ask for your personal and financial information, including your current and past addresses, Social Security number, employer, and income details.

Once you submit your application, the bank will evaluate your application and credit history to determine whether to approve you for the loan. If approved, the lender will send you the funds and details of your loan terms.

Associated costs

Depending on the type of loan and the lender, there will be extra costs. In addition to the interest on the amount owed, a borrower may also need to pay origination fees, insurance, application fees, and other fees.

Some of the main costs you should consider include:

  • Interest: The most common types of interest rates will be fixed or variable.
  • Arrangement fees: The lender charges an arrangement fee for setting up the loan. Arrangement fees usually pertain to mortgages or business loans.
  • Insurance: Purchasing insurance may be a condition of some loans, while others offer it as an optional add-on.
  • Origination fee: Origination fees are paid to a lender to process a loan application. The lender charges these fees when your loan is approved, as a percentage of the amount you borrow.
  • Application fee: Some lenders might charge a fee to apply.
  • Late fee: A lender might charge a fee for late loan payments.

Repayment process

If your bank loan is an installment loan, you’ll make monthly payments on a predetermined schedule. These payments will be the same amount each month, but if you want to pay off your loan more quickly, you can make extra payments to the principal of the loan. Any extra payments toward the principal will reduce the amount you pay in interest over the life of the loan.

For a personal line of credit, you’ll have variable interest payments based on your current balance, and your monthly payments may vary.

FAQs

A bank loan can help you reach your goals

Bank loans are an umbrella term for a wide range of loans offered by a bank. There are some things you can do to better your odds of getting approved for a loan, such as building your credit, reviewing your credit report, and increasing your income.

Once you secure a loan, make sure to fit your debt payments into your monthly schedule.

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Opinions, advice, services, or other information or content expressed or contributed here by customers, users, or others, are those of the respective author(s) or contributor(s) and do not necessarily state or reflect those of The Bancorp Bank, N.A. and Stride Bank, N.A. (“Banks”). Banks are not responsible for the accuracy of any content provided by author(s) or contributor(s).

1 Information from Value Penguin's Average Personal Loan Interest Rates as of January 5, 2023: https://www.valuepenguin.com/personal-loans/average-personal-loan-interest-rates

2 Information from LendingTree's What Credit Score Is Needed to Buy a Car? as of January 5, 2023: https://www.lendingtree.com/auto/what-credit-score-is-needed-to-buy-a-car/

3 Information from CNBC's What credit score is required to buy a house? as of January 5, 2023: https://www.cnbc.com/select/credit-score-needed-to-buy-house/

4 Information from Lendedu's What Credit Score Do I Need for a Student Loan? as of January 5, 2023: https://lendedu.com/blog/student-loan-credit-score/

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