What is a Loan?
A loan is money, property or other material goods given to another party in exchange for future repayment of the loan value amount, along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as an open-ended line of credit up to a specified limit or ceiling amount.
Loans can come from individuals, corporations, financial institutions and governments. They offer a way to grow the overall money supply in an economy, as well as open up competition and expand business operations. The interest and fees from loans are a primary source of revenue for many financial institutions, such as banks, as well as some retailers through the use of credit facilities.
How a Loan Works
The terms of a loan are agreed to by each party in the transaction before any money or property changes hands. If the lender requires collateral, this requirement will be outlined 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.
Types of Loans
A number of different factors can differentiate loans and affect their costs and terms.
Secured vs. Unsecured Loan
Loans such as credit cards and signature loans are unsecured or not backed by collateral. Unsecured loans typically have higher interest rates than secured loans, as they are riskier for the lender. With a secured loan, the lender can repossess the collateral in the case of default. However, interest rates vary wildly depending on multiple factors.
Revolving vs. Term
Loans can also be described as revolving or term. Revolving refers to a loan that can be spent, repaid and spent again, while term refers to a loan paid off in equal monthly installments over a set period (the 'term'). 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.
Special Considerations for Loans
Interest rates have a huge effect on loans: Loans with high interest rates have higher monthly payments – or take longer to pay off – than loans with low 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 next five years. In contrast, if the interest rate is 9%, the payments climb to $103.79.
[Important: Loans with high interest rates have higher monthly payments – or take longer to pay off – than loans with low interest 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 a simple interest or a compound interest. Simple interest is interest on the principal loan, which banks almost never charge borrowers. For example, if 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%, this means that the borrower will have to pay the bank the original loan amount of $300,000 x 1.15 = $345,000.
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 on the principal, but also on 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 second year, the borrower owes it the principal and the interest for the first year plus the interest on interest for the first year.
The interest owed when compounding is taken into consideration is higher than that of the simple interest method because interest has been charged monthly on the principal loan amount including accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, the disparity between the two types of interest calculations grows.