Denice R. Preston
What is a loan?
A loan is a credit instrument that lends money to another party in return for future repayment of principal or value. The lender may also charge interest and finance fees to the principal value, which the borrower must pay in addition to the principal amount. The loan may be for a one-time sum, or it may be open to an unlimited amount of credit. Many types of loans are available, including personal, secured, and commercial loans.
KEY TAKEAWAYS
- A loan refers to money given to someone in return for the principal amount and interest.
- Each party must agree to the loan terms before any money can be advanced.
- A loan can be secured with collateral, such as a mortgage, or it could be unsecured like a credit card.
- Revolving loans and lines can be used, repaid and repaid again. On the other hand, term loans are fixed-rate, fixed payment loans.
Understanding Loans
A loan is any debt that an individual or entity incurs. A lender is usually a financial institution, government, or corporation that advances money to the borrower. The borrower agrees to pay a set of terms, including interest, finance charges, and repayment dates. The lender may ask for collateral to secure the loan and guarantee repayment. Bonds and certificates of deposit (CDs) may be used as collateral for loans. You can also borrow money from your 401(k).
Here are the steps involved in getting a loan. A loan is a loan that someone can apply for from a bank or corporation. The borrower might be asked to give specific information such as the reason for borrowing, financial history, Social Security Number (SSN) and other details. The lender will review the information to determine if the loan is possible to repay. This includes the person’s debt/income ratio (DTI). The lender will decide whether to approve or deny the application based on creditworthiness. If the application is denied, the lender must give a reason. Both parties must sign a contract detailing the terms of the agreement if the loan application is approved. After the lender advances the loan proceeds, the borrower must repay the amount plus any additional interest.
Before any money or property is transferred or disbursed, each party must agree to the loan terms. The loan documents will state that the lender may require collateral if necessary. Many loans have clauses regarding the maximum interest rate and other covenants, such as the period before repayment.
There are many reasons why loans can be arranged, including major purchases, investments, renovations, debt consolidation and business ventures. Existing companies can also benefit from loans to expand their operations. Lending to new companies opens up the market for competition and allows for an increase in the economy’s money supply. Many banks and retailers make their primary revenue from interest and fees on loans. Some also use credit facilities and credit card cards to fund their business.
Special Considerations
The interest rates have a major impact on loans and, ultimately, the cost of borrowing. Higher interest rates can lead to higher monthly payments or take longer to repay than loans with lower rates. A person borrowing $5,000 for a term or instalment loan at 4.5% interest rates will face a $93.22 monthly payment over the next five years. The payments will rise to $103.79. If the interest rate is 9%, however,
Higher interest rates mean higher monthly payments. This means that they are more expensive than loans at lower rates.
Similar to the above, if someone owes $10,000 on a credit card with a rate of 6% and they pay $200 per month, it will take them almost five years to pay off their balance. It will take 108 months to pay the card off with a 20% interest rate and the same balance.
Simple vs Compound interest
You can set the interest rate on loans at either simple or compound interest. Simple interest is the interest on the principal loan. Banks rarely charges simple interest to borrowers. Let’s take, for example, a person who takes out a $300,000.00 mortgage. The loan agreement states that the interest rate is 15% per year. The borrower will be responsible for paying the bank $345,000, or $300,000 x 1.15.
Compounded interest is interest on interest. This means that the borrower must pay more interest. The interest is applied not only to the principal but also to any accumulated interest from previous periods. The bank assumes that the borrower owes the principal and interest for the first year. The borrower owes the bank the principal, interest and interest for the second year.
Compounding has a higher interest rate than the simple interest method. This is because interest is charged monthly on the principal amount of the loan, plus accrued interest from previous months. Both methods can be used to calculate interest for shorter periods. The difference between these two types of interest calculation grows as the lending period increases.
A personal loans calculator will help you determine the best interest rate for you.
Types Of Loans
There are many types of loans. Many factors can help differentiate between the cost of loans and their contractual terms.
- Secured vs Unsecured Loan
You have two options when it comes to loans: unsecured or secured. Both car loans and mortgages are secured loans because they are secured or backed by collateral. The collateral in these cases is the asset that is being used to secure the loan. For example, a home as collateral for a mortgage and a vehicle as collateral for a car loan. If required, borrowers may need to provide additional collateral to secure other types of secured loans.
Unsecured loans include signature loans and credit cards. They are not secured by collateral. Because of the higher risk of default, unsecured loans have higher interest rates than secured loans. Because a secured lender can take over collateral if the borrower defaults, unsecured loans have higher interest rates than secured loans. Unsecured loans can have rates that vary greatly depending on many factors, including credit history and the borrower.
- Revolving vs Term Loan
Revolving and term loans are also possible. Revolving loans can be used, repaid and repaid again. A term loan is a loan that is paid in equal monthly payments over a specified period. A credit card is an unsecured, revolving credit loan. However, a home equity line-of-credit (HELOC) is a secured, permanent loan. A car loan is a secured term loan, while a signature loan can be unsecured.
