What Is a Loan?
The term loan refers to a type of credit vehicle in which a sum of money is lent to another party in exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest and/or finance charges to the principal value which the borrower must repay in addition to the principal balance. Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms including secured, unsecured, commercial, and personal loans.
- A loan is when money is given to another party in exchange for repayment of the loan principal amount plus interest.
- Loan terms are agreed to by each party before any money is advanced.
- A loan may be secured by collateral such as a mortgage or it may be unsecured such as a credit card.
- Revolving loans or lines can be spent, repaid, and spent again, while term loans are fixed-rate, fixed-payment loans.
A loan is a form of debt incurred by an individual or other entity. The lender—usually a corporation, financial institution, or government—advances a sum of money to the borrower. In return, the borrower agrees to a certain set of terms including any finance charges, interest, repayment date, and other conditions. In some cases, the lender may require collateral to secure the loan and ensure repayment. Loans may also take the form of bonds and certificates of deposit (CDs). It is also possible to take a loan from a 401(k) account.
Here's how the loan process works. When someone needs money, they apply for a loan from a bank, corporation, government, or other entity. The borrower may be required to provide specific details such as the reason for the loan, their financial history, Social Security Number (SSN), and other information. The lender reviews the information including a person's debt-to-income (DTI) ratio to see if the loan can be paid back. Based on the applicant's creditworthiness, the lender either denies or approves the application. The lender must provide a reason should the loan application be denied. If the application is approved, both parties sign a contract that outlines the details of the agreement. The lender advances the proceeds of the loan, after which the borrower must repay the amount including any additional charges such as interest.
The terms of a loan are agreed to by each party before any money or property changes hands or is disbursed. If the lender requires collateral, the lender outlines this in the loan documents. Most loans also have provisions regarding the maximum amount of interest, as well as other covenants such as the length of time before repayment is required.
Loans are advanced for a number of reasons including major purchases, investing, renovations, debt consolidation, and business ventures. Loans also help existing companies expand their operations. Loans allow for growth in the overall money supply in an economy and open up competition by lending to new businesses. The interest and fees from loans are a primary source of revenue for many banks, as well as some retailers through the use of credit facilities and credit cards.
Interest rates have a significant effect on loans and the ultimate cost to the borrower. Loans with higher interest rates have higher monthly payments—or take longer to pay off—than loans with lower interest rates. For example, if a person borrows $5,000 on an installment or term loan with a 4.5% interest rate, they face a monthly payment of $93.22 for the following five years. In contrast, if the interest rate is 9%, the payments climb to $103.79.
Higher interest rates come with higher monthly payments, meaning they take longer to pay off than loans with lower rates.
Similarly, if a person owes $10,000 on a credit card with a 6% interest rate and they pay $200 each month, it will take them 58 months, or nearly five years, to pay off the balance. With a 20% interest rate, the same balance, and the same $200 monthly payments, it will take 108 months, or nine years, to pay off the card.
Simple vs. Compound Interest
The interest rate on loans can be set at simple or compound interest. Simple interest is interest on the principal loan. Banks almost never charge borrowers simple interest. For example, let's say an individual takes out a $300,000 mortgage from the bank, and the loan agreement stipulates that the interest rate on the loan is 15% annually. As a result, the borrower will have to pay the bank a total of $345,000 or $300,000 x 1.15.
Compound interest is interest on interest and means more money in interest has to be paid by the borrower. The interest is not only applied to the principal but also the accumulated interest of previous periods. The bank assumes that at the end of the first year, the borrower owes it the principal plus interest for that year. At the end of the second year, the borrower owes it the principal and the interest for the first year plus the interest on interest for the first year.
With compounding, the interest owed is higher than that of the simple interest method because interest is charged monthly on the principal loan amount, including accrued interest from the previous months. For shorter time frames, the calculation of interest is similar for both methods. As the lending time increases, the disparity between the two types of interest calculations grows.
Types of Loans
Loans come in many different forms. There are a number of factors that can differentiate the costs associated with them along with their contractual terms.
Secured vs. Unsecured Loan
Loans can be secured or unsecured. Mortgages and car loans are secured loans, as they are both backed or secured by collateral. In these cases, the collateral is the asset for which the loan is taken out, so the collateral for a mortgage is the home, while the vehicle secures a car loan. Borrowers may be required to put up other forms of collateral for other types of secured loans if required.
Credit cards and signature loans are unsecured loans. This means they are not backed by any collateral. Unsecured loans usually have higher interest rates than secured loans because the risk of default is higher than secured loans. That's because the lender of a secured loan can repossess the collateral if the borrower defaults. Rates tend to vary wildly on unsecured loans depending on multiple factors including the borrower's credit history.
Revolving vs. Term Loan
Loans can also be described as revolving or term. A revolving loan can be spent, repaid, and spent again, while a term loan refers to a loan paid off in equal monthly installments over a set period. A credit card is an unsecured, revolving loan, while a home equity line of credit (HELOC) is a secured, revolving loan. In contrast, a car loan is a secured, term loan, and a signature loan is an unsecured, term loan.