How Do Bank Loans Work? Types, Requirements and Approval Tips

A bank loan might be the best solution when you need to borrow money to make a large purchase or to cover unexpected expenses. To save money over the life of the loan, take time to research and find the best personal loan rates. We explore how bank loans work today.

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Types of Bank Loans

Take a look at some of the most common types of bank loans below:

• Personal loans. The funds from a personal loan can be used to cover almost any purchase. You might use the funds for debt consolidation, medical bills, home repairs, celebration expenses and more. Although many personal loans are unsecured, some personal loans require collateral.

• Auto loans. An auto loan can be used to purchase a vehicle. Typically, an auto loan is secured by the vehicle you purchase with the funds.

• Mortgage loans. Banks offer mortgage loans to help a borrower pay for a home purchase. Typically, these large loans come with loan repayment terms of 15 to 30 years with either fixed or adjustable interest rates. Your home serves as the underlying collateral, which means if you cannot keep up with the mortgage payments, the bank might foreclose on your property.

• Business loans. Many banks offer business loans to both small and large businesses for any number of business expenses. Depending on the situation, the loan might be secured by business assets or unsecured.

• Student loans. Some banks offer private student loans to help students pay for educational expenses, like tuition, books and living expenses. Unlike federal student loans, private student loans don't offer attractive borrower protections, like student loan forgiveness or income-based repayment options.

• Home equity loan. These types of loans are a secured way to get financing for expenses like home improvements. You can get much lower rates than an unsecured personal loan and use your home as collateral.

How the Bank Loan Process Works

Although the specifics of obtaining a bank loan vary slightly from one financial institution to another, the overall process tends to look similar. Below is a look at how the process usually works:

1. Loan application. The process starts when you submit a loan application. Be prepared to share information about your income, employment, credit history and loan purpose.

2. Credit evaluation. Banks will review your situation, including looking at your credit score, financial history and debt-to-income ratio.

3. Loan approval or denial. Depending on the bank's evaluation of your application, they'll approve or deny the loan request. Alternatively, the bank might request more information about your situation.

4. Loan terms and agreement. If you're approved for the loan, the bank will send over documents outlining the loan terms, interest rates, repayment period and fees. It's important to carefully review this information to confirm you are comfortable with the details of the loan before moving forward.

5. Loan disbursement. If you accept the loan, the funds might be disbursed as a lump sum or line of credit.

6. Loan repayment. Once you receive the loan, you'll start making payments based on your loan terms. In many cases, you might make regular monthly payments of principal and interest. If you want to repay the loan early, that's often an option. But check into prepayment penalties before moving forward.

Before starting the process with any particular bank, it's a good idea to shop around to find out which bank offers the lowest interest rates and fees.

Secured vs Unsecured Bank Loans

The loans can be secured — attached to collateral like a car — or unsecured. When you have a secured loan, the lender can seize the asset if you don't keep up with your scheduled payments.

The table below outlines the differences between secured and unsecured loans.

Factors That Affect Loan Approval

When it comes to getting approved for a bank loan, many factors come into play. Below is a look at some of the most important factors:

• Credit score. Typically, borrowers with higher credit scores enjoy lower interest rates and better approval chances.

• Income and employment. Most lenders prefer to work with borrowers who have stable incomes to support loan repayment.

• Debt-to-income ratio (DTI). Your DTI reflects how much of your monthly income is consumed by your current debts. In general, a lower DTI indicates more bandwidth to repay the loan.

• Collateral. Depending on the loan, you may or may not need to provide collateral. Typically, providing collateral leads to better approval odds.

To qualify for a loan, you must meet basic eligibility requirements. The bank will look at your personal credit history, credit score, the amount of debt you currently owe and your payment history. Banks will consider how much you currently make compared to your debt load with your new loan. If you owe too much money, you might not be approved for a new loan.

Tips for Getting Approved for a Bank Loan

If you want to get approved for a bank loan, use the following tips to improve your chances.

• Check your credit. Before you apply for a loan, check your credit to see where you stand. Depending on your situation, you might find a great credit score, which could make getting a loan easier.

• Improve your credit. If your credit score isn't where you want it to be, consider working on your credit before applying for a bank loan. For example, you might commit to making on-time payments and paying down debt for the next year to potentially improve your credit score.

• Lower your DTI ratio. Make an effort to lower your DTI by paying off some of your existing debts. When possible, start by paying down your high-interest debt, like credit card balances, ahead of schedule.

• Gather your documents ahead of time. You'll need lots of paperwork to get approved for a loan. Making the effort to gather your documents, like proof of income and your Social Security number, ahead of time can speed up the process.

Is a Bank Loan Right for You?

Whether or not a bank loan is right for you depends on your situation. Before applying to a bank loan, do your research and assess your budget to confirm you can support the ongoing payment. If you can afford the payments and the loan fits into your long-term financial goals, then a bank loan might be right for you. If you aren't sure how you'd swing the monthly payment, then a bank loan might not be right for you.

FAQs

What credit score is needed for a bank loan?

Every bank can set unique credit score requirements. With that, the credit score required varies from bank to bank. Generally, a higher credit score leads to better approval odds and lower interest rates.

How long does it take to get approved for a bank loan?

The speed of approval varies based on the bank. Depending on the situation, it might take a couple of hours or several weeks to get approved for a loan.

Can I get a bank loan with bad credit?

Some banks work with borrowers who have bad credit. But others won't. If you want to get a bank loan with bad credit, shop around to find a lender willing to work with you.

What is the difference between a fixed and variable interest rate?

A fixed interest rate remains the same over the life of the loan. A variable interest rate can change over the life of the loan.

Are there penalties for paying off a bank loan early?

Some banks impose prepayment penalties on borrowers who repay their loans ahead of schedule. Others don't. Read the fine print of a loan document before signing to find out about potential prepayment penalties.

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