Understanding How Borrowing and Lending Works

Understanding How Borrowing (and Lending) Works

Learning how lending works is not only important while you’re in college and looking for student loans but also for life in general. While the nitty-gritty of borrowing (and lending) may vary depending on the type of loan you’re seeking (student loan, car loan, mortgage, etc.), the general principles can be applied across the board.

In the most basic sense, lending is the act of giving money to someone now with the expectation they will pay you back in the future. Usually, lenders are reimbursed by ongoing, monthly payments made by the borrower until the total amount owed is received. In return for lending the money, the lender charges the borrower a percentage of the amount borrowed, which is known as an interest rate.

In general, the lender determines the interest rate, and it reflects the likelihood that the borrower will repay the amount owed on time. Lenders use different ways to calculate interest rates, but typically an individual’s credit score has a lot to do with it since that’s how the lender predicts an individual’s ability and likelihood to pay (higher credit score = lower interest rate).

Note: Federal student loans do not exactly work this way. You can learn more by visiting our resource on Federal vs. Private Student Loans.

Borrowing (and Lending) Money: A Simplified Example

You (borrower) need $5,000 (loan amount) to cover the remaining balance of your tuition, so you go to your favorite uncle, Uncle Rick (lender), to ask for the money. Uncle Rick says sure, but he also says he’ll charge you 5% a year (interest rate) in return for lending you the money, and all of the money must be repaid in 10 years (repayment term).

While getting into the details of lending can be complex, the basic principles are fundamentally simple. Don’t let the big words or sophisticated calculations confuse you.

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