Loan Terms Glossary: Every Term Explained
Not financial advice. This guide is for information only. It is not a recommendation to borrow, lend, invest or take any financial action. Read the full disclaimer.
Understanding loan terminology helps you make better borrowing decisions.
Loan terminology is where borrowers lose money, because almost every expensive feature of a loan is named in the documents rather than on the advertisement. The terms that most directly determine what you pay are APR (annual percentage rate — the all-in cost including fees), origination fee (a percentage deducted from your proceeds), amortisation (how the payment splits between interest and principal), and prepayment penalty (a fee for paying off early). Understanding these four, plus the rate-versus-APR distinction, prevents most of the costly mistakes in consumer lending.
The rate vs APR distinction, and why it matters most
The interest rate is what the lender charges on the outstanding balance. The APR is the interest rate plus the effect of fees, expressed as an annualised cost. On a mortgage with $4,000 of fees, a 6.4% note rate can have an APR of about 6.55%. On a personal loan with a 5% origination fee, a 15% rate can have an APR above 17%.
The regulatory reason this exists: the Truth in Lending Act requires lenders to disclose the APR so you can compare loans with different fee structures. The practical use: compare APR, not rate, unless you are certain you will keep the loan for a very long time and the fees are small.
One important exception — if you are comparing loans with very different fee structures and expect to prepay or refinance fairly soon, the APR actually overstates the cost of the high-fee loan, because the fee is amortised over the full term rather than the shorter life you will actually have it.
Amortisation and prepayment penalties
Under amortisation, early payments go mostly to interest and later payments mostly to principal. On a 30-year fixed mortgage at 6.4%, roughly 78% of your first monthly payment is interest; by year 20, it is under 30%. This is why extra payments early in a loan have a disproportionate effect — a $200 extra principal payment in month 2 saves far more than $200 paid in year 25.
A prepayment penalty is a charge for paying the loan off early, usually 1-4% of the remaining balance and typically time-limited to the first 3-5 years. It exists because the lender priced the loan assuming a stream of interest payments. Always check this clause: it is sometimes buried, and it can remove entirely the benefit of refinancing.
Two more terms worth memorising: capitalisation is when unpaid interest is added to principal, so you then pay interest on interest — common on student loans after deferment. DSCR (debt service coverage ratio) is a business-lending term: net operating income divided by debt service, and most commercial lenders want 1.25 or higher.
Worked example: how an origination fee changes the real cost
Two personal loan offers for $15,000 over 5 years. Offer A: 14.0% rate, 6% origination fee. Offer B: 15.5% rate, no fee.
Offer A: you receive $14,100 but repay $15,000 plus interest over 60 months at 14% — about $349/month, total interest roughly $5,940. Total cost above the money received: $900 (fee) + $5,940 = $6,840, or about 9.7% of the $14,100 you actually got. Offer B: you receive $15,000 and repay about $362/month, total interest roughly $6,700. Total cost above the money received: $6,700, or 44.7% of $15,000.
On total dollars, Offer A costs $140 more, but on a per-dollar-borrowed basis Offer B is cheaper — because Offer A gave you less money for the same repayment. The APR for Offer A works out higher once the fee is included. This is exactly why comparing APRs rather than rates prevents the error.
Key loan terms and what each one costs you
| Term | What it means | Why it matters |
|---|---|---|
| Interest rate | Annual cost on the outstanding balance | The headline number, but not the full cost |
| APR | Rate plus fees, annualised | The number to compare between offers |
| Origination fee | Percentage deducted from proceeds | You repay it but never receive it |
| Amortisation | Split of each payment between interest and principal | Early payments are mostly interest |
| Prepayment penalty | Fee for paying off early | Can eliminate the benefit of refinancing |
| Capitalisation | Unpaid interest added to principal | You then pay interest on interest |
| Escrow | Account holding taxes and insurance with your payment | Changes your monthly payment, not the rate |
| DSCR | Income available for debt service / debt service | Business lending threshold, usually 1.25+ |
| PMI / MIP | Insurance required on low-down-payment mortgages | Costs 0.3-1.5% of loan balance annually |
Risks and Points of Caution
- Comparing rate instead of APR on loans with different fee structures leads to the wrong choice.
- Prepayment penalties can make refinancing uneconomic and are easy to miss in the documents.
- A shorter term lowers the rate but raises the monthly payment — check affordability, not just cost.
- Adjustable-rate loans quote an introductory rate that is not the rate you will pay for most of the term.
- Capitalisation quietly grows a balance during deferment or forbearance.
What to do next
Before signing anything, run through this checklist.
- Ask each lender for the APR, not just the interest rate, in writing.
- Request the full fee schedule and identify any origination, processing, or prepayment fees.
- Calculate the total dollar cost: sum all payments, then subtract the amount you actually receive.
- Read the prepayment penalty clause and note how long it applies.
- Confirm whether the rate is fixed or adjustable, and if adjustable, what the index and caps are.
- Ask what the payment would be if the term were 5 years shorter — it often reveals a better fit.
Sources and Further Reading
- Truth in Lending Act (Regulation Z)Consumer Financial Protection Bureau
- What is the difference between a mortgage interest rate and an APR?Consumer Financial Protection Bureau
- Choosing a LoanFederal Trade Commission
Sources were consulted when this guide was last reviewed. Where a figure is a range, it reflects the spread across the sources listed rather than a single quoted number. See our source policy and fact-checking process.
Key Takeaways
- APR includes fees and is the correct number for comparing loans with different structures.
- Origination fees are deducted from proceeds — you repay them but never receive them.
- Early amortised payments are mostly interest, so extra principal early saves the most.
- Check the prepayment penalty clause before assuming refinancing will save money.
Frequently Asked Questions
Is a lower interest rate always better?
No. A loan with a lower rate but a large origination fee can cost more than one with a slightly higher rate and no fee. Compare APRs and total dollars repaid.
What is a good DSCR for a business loan?
Most commercial lenders want a DSCR of at least 1.25, meaning net operating income covers debt service 1.25 times. Below 1.0, the business is not generating enough income to cover its debt.
What does capitalisation mean on a student loan?
It means unpaid interest is added to your principal balance, usually at the end of a deferment or forbearance period. From then on you pay interest on that interest, so the balance grows faster.