What is a loan?
A loan is money, property, or other material property given to another party in exchange for a future repayment of the value of the loan or the amount of principal, as well as interest or finance charges. A loan may be for a specific one-time amount or may be available as an indefinite line of credit up to a specified limit or limit.
Loans are generally issued by companies, financial institutions and governments. Loans allow the growth of the overall money supply in an economy and open up competition by lending to new businesses. The loans also help existing businesses to develop their operations. Interest and loan charges are a major source of income for many banks, as well as for some retailers through the use of credit facilities and credit cards. They can also take the form of bonds and certificates of deposit. It is possible to take out a loan from a person’s 401 (k). Often, a person’s debt-to-income ratio is analyzed to see if a loan can be repaid.
How a loan works
The terms of a loan are agreed to by each party to the transaction before the money or property changes hands or is disbursed. If the lender requires collateral, this requirement will be described in the loan documents. Most loans also have provisions for the maximum amount of interest, as well as other covenants such as the time before repayment.
Key points to remember
- A loan is when money or assets are given to another party in exchange for repayment of the loan principal plus interest.
- Loans with high interest rates have higher monthly payments – or take longer to repay – than loans with low rates.
- Loans can be secured by collateral like a mortgage or unsecured like a credit card.
- Revolving loans or lines can be spent, repaid and spent again, while term loans are fixed rate and fixed payment loans.
Types of loans
A number of factors can differentiate loans and affect their costs and conditions.
Secured or unsecured loan
Loans can be secured or unsecured. Mortgages and auto loans are secured loans because they are both secured or collateralized.
Loans such as credit cards and signature loans are unsecured or unsecured. Unsecured loans usually have higher interest rates than secured loans because they are more risky for the lender. With a secured loan, the lender can repossess the collateral in the event of default. However, interest rates vary widely on unsecured loans depending on several factors, including the borrower’s credit history.
Renewable or term
Loans can also be described as revolving or term. Revolving credit refers to a loan that can be spent, repaid, and spent again, while term loans refer to a loan repaid in equal monthly installments over a given period. A credit card is an unsecured revolving loan, while a home equity line of credit (HELOC) is a guaranteed revolving loan. In contrast, a car loan is a guaranteed term loan and a signature loan is an unsecured term loan.
Special considerations for loans
Interest rates have a significant effect on loans and the final cost to the borrower. High interest loans have higher monthly payments – or take longer to repay – than low interest loans. For example, if someone borrows $ 5,000 on an installment or term loan with an interest rate of 4.5%, they face a monthly payment of $ 93.22 for the next five years. On the other hand, if the interest rate is 9%, the payments increase to $ 103.79.
High interest loans have higher monthly payments – or take longer to repay – than low interest loans.
Likewise, if someone owes $ 10,000 to a credit card with an interest rate of 6% and pays $ 200 each month, it will take 58 months, or almost five years, to pay off the balance. . With an interest rate of 20%, the same balance and the same monthly payments of $ 200, it will take 108 months, or nine years, to repay the card.
Simple interest vs. compound interest
The interest rate on loans can be set at simple interest or compound interest. Simple interest is interest on the principal loan, which banks hardly ever charge borrowers.
For example, suppose a person takes out a $ 300,000 mortgage with the bank and the loan agreement states that the interest rate on the loan is 15% per year. Consequently, the borrower will have to pay the initial loan amount of $ 300,000 x 1.15 = $ 345,000 to the bank.
Compound interest is interest on interest and means that more money in interest has to be paid by the borrower. Interest is applied not only to the principal but also to the interest accrued from previous periods. The bank assumes that at the end of the first year, the borrower owes him the principal plus the interest for that year. At the end of the second year, the borrower owes him the principal and the interest for the first year plus interest on the interest for the first year.
The interest due, when the composition is taken into account, is higher than that of the simple interest method, because interest has been charged monthly on the principal loan amount, including the interest accrued from previous months. For shorter periods, the interest calculation will be similar for the two methods. As loan time increases, the disparity between the two types of interest calculations increases.