Loan Basics: What They Are, When to Borrow, and How to Repay Wisely

Loans are one of the most common financial tools people use, yet they are often misunderstood.

Whether it’s a mortgage, car payment, or student debt, borrowing money affects nearly every household. Knowing how loans work can help you make informed decisions that support your financial goals instead of holding them back.

What Is a Loan?

A loan is money borrowed from a lender that you agree to pay back, with interest, over time. The loan agreement outlines four main parts:

• Principal: The amount you borrow.
• Interest rate: The cost of borrowing, shown as a percentage.
• Term: How long you have to repay the loan.
• Payment schedule: When and how much you’ll pay, typically each month.

Each payment includes both principal and interest. In the early months, most of your payment goes toward interest; later, more goes toward the principal balance.

According to the Federal Reserve’s Consumer Credit Report, U.S. household debt surpassed $17.5 trillion in 2025, mostly in mortgages, student loans, and auto loans.¹ This makes understanding how loans work essential for long-term financial health.

Good Loans and Bad Loans

There’s no official list of “good” or “bad” loans, but some borrowing tends to improve financial stability while other types can make it harder to reach goals.

Generally helpful loans include:

• Mortgages: They allow you to buy a home that can build equity over time.
• Student loans: Education may increase your earning potential.
• Business loans: Borrowing to grow or start a business can generate income in the future.

Potentially harmful loans include:

• High-interest credit cards: These can cost far more than the items purchased.
• Payday or short-term loans: Fees and triple-digit annual rates can trap borrowers in cycles of debt.
• Large car loans: Vehicles lose value quickly, which can leave borrowers owing more than the car is worth.

The Consumer Financial Protection Bureau (CFPB) estimates that short-term loans can carry annual percentage rates above 300%, compared to average credit card rates near 22%.²

When Borrowing Makes Sense

Borrowing can make sense when it supports long-term progress and fits comfortably within your budget.

You might consider taking a loan if:

1. The purchase can grow in value or increase your income (a home, education, or business).
2. Monthly payments fit easily within your income and expenses.
3. You have reviewed multiple lenders and compared total costs, not just monthly payments.

The FDIC recommends keeping total debt payments under 40% of your gross monthly income, including housing, car, and credit payments.³

Repaying Loans the Smart Way

Paying off debt doesn’t have to be complicated. These steps can make repayment faster and less expensive:

1. Pay on time. Automatic payments can prevent late fees and credit score damage.
2. Pay more than the minimum. Even small extra payments reduce interest over time.
3. Tackle high-interest balances first. This is known as the avalanche method.
4. Refinance when rates fall. Lower interest can shorten your term or reduce monthly costs.
5. Build a cash buffer. An emergency fund keeps you from turning to high-interest credit when unexpected expenses arise.

According to Experian, U.S. borrowers who make one additional payment per year on a 30-year mortgage can cut the loan term by roughly four years.⁴

Questions to Ask Before Taking Any Loan

Before you borrow, ask yourself:

• What am I borrowing for, and is it essential?
• How much will this loan cost in total, including interest?
• Can I afford the payment if my income drops or expenses rise?
• What happens if I pay it off early or refinance later?

The goal is to borrow with purpose and a clear plan to repay, not just because credit is available.

The Bottom Line

Loans can be tools for progress or sources of stress. The difference lies in how they’re used. Borrow thoughtfully, focus on affordable payments, and pay down high-interest debt as soon as you can.

If you want help understanding how borrowing fits into your overall financial plan, OneDigital’s advisors can guide you toward decisions that support both short-term stability and long-term goals.

Looking for more information or to speak with an advisor? Visit our Financial Academy page for educational resources to help you do your best work and live your best life.

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Investment advice offered through OneDigital Investment Advisors LLC.

¹ Federal Reserve: “Consumer Credit – G.19 Release”

² Consumer Financial Protection Bureau: “Payday Loans, Auto Title Loans, and High-Cost Installment Loans”

³ FDIC: “Debt-to-Income Ratio Basics”

⁴ Experian: “How One Extra Payment a Year Can Shorten Your Mortgage”