What is a loan?
A loan is a credit instrument that lends money to another person in return for future repayments of the value or principal amount. In many cases, the lender may also add interest or finance charges on the principal value. The borrower will have to repay the principal balance.
A loan can be for a one-time, fixed amount or it could be an unlimited line of credit with a limit. There are many types of loans, including personal, commercial and secured.
KEY TAKEAWAYS
- A loan is money that is given to someone in return for the principal amount and interest.
- Before granting a loan, lenders will assess the income, credit score, debt level, and credit history of the prospective borrower.
- Secured collateral, such as a mortgage, or unsecured collateral such as credit cards can be used to secure a loan.
- Revolving loans and lines can be used, repaid, then spent again. Term loans, on the other hand, are fixed-rate, fixed payment loans.
- Lenders might charge risky borrowers higher interest rates.
Understanding Loans
A loan is a type of debt that an individual or entity takes out. Lenders are usually a government, corporation or financial institution that lend money to the borrower. The borrower agrees that they will comply with certain terms, including any finance costs, interest, repayment dates, and other conditions.
Sometimes, the lender might require collateral in order to secure the loan and guarantee repayment. You can also borrow money in the form of certificates of deposit (CDs) or bonds. You can also borrow money from a or 401(k), account.
The Loan Process
Here are the steps involved in getting a loan. A loan is a loan that someone can apply for from a bank or corporation. You may need to give specific information such as your reason for borrowing, financial history, Social Security number (SSN) and other details. To determine if the loan is possible to repay, the lender will review the information. This includes the debt/to-income ratio.
The lender will decide whether to approve or deny the loan application based on the applicant’s creditworthiness. If the loan 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 proceeds of a loan, the borrower must repay all amounts including interest.
Before any money, property or funds are disbursed, each party must agree to the terms of the loan. The loan documents will state whether the lender needs collateral. Many loans have provisions about the maximum interest rate and other covenants, such as the time period before repayment.
What are the benefits of loans?
There are many reasons why loans can be advanced, including major purchases, investment, renovations and debt consolidation. Also, loans can be used to expand the operations of companies. By lending to new companies, loans can help increase the overall money supply of an economy.
Many banks make their primary revenue from interest and fees on loans. Some retailers also use credit facilities or credit cards.
Components of a loan
There are many important terms that will determine the loan amount and the speed at which the borrower can repay it.
- Principal – This is the initial amount of money being borrowed.
- Loan Term – The time the borrower must repay the loan.
- Interest rate: This is the rate at which money owed increases. It’s usually expressed as an annual percent rate (APR).
- Loan Payments – The amount that must be paid each month or every week to fulfill the loan terms. This can be calculated using an amortization chart.
The lender might also add additional fees such as an origination charge, service fee or late payments fees. Larger loans may require collateral such as real property or a vehicle. These assets can be taken to repay the debt if the borrower defaults.
Tips for Getting a Loan
Prospective borrowers must prove that they can repay the lender in order to be eligible for a loan. Lenders consider several factors when deciding whether a borrower is worth taking on.
- Income: Lenders may ask for a certain income level to ensure that the borrower can afford their loans. In the case of home mortgages, they may require years of steady employment.
- Credit Score A credit score is a numerical representation that a person’s creditworthiness. It is calculated based on their borrowing history and repayment history. A person’s credit score can be severely damaged by missing payments or bankruptcies.
- The Debt-to–Income Ratio Lenders also check the borrower’s credit history to see how many loans they have. High levels of debt indicate that the borrower might have trouble repaying their debts.
It is essential to show that you are able to responsibly use debt to improve your chances of getting a loan. Avoid taking on unnecessary debt and pay off credit cards and loans promptly. You will also be eligible for lower interest rates.
You can still qualify for loans even if you have high debts or poor credit scores, but they will most likely have a higher interest rate. These loans are more costly in the long-term so it is a good idea to improve your credit score and debt-income ratio.
Relationship between interest rates and loans
The interest rates have an important impact on loans and the final cost to the borrower. Higher interest rates can lead to higher monthly payments or take longer repayments than loans with lower rates. A person borrowing $5,000 for a term or installment 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 rates are 9%.
Higher interest rates mean higher monthly payments. This means that they are more difficult to repay than loans at lower rates.
Similar to the above, a person who owes $10,000 on credit card with a rate of 6% and pays $200 per month will take 58 months or almost five years to pay off the balance. It will take 108 months to pay off the card with a 20% interest rate and the same balance.
Simple vs. Simple vs. compound interest
You can set the interest rate on loans at either simple or compound interest. Simple interest refers to the principal loan. Simple interest is almost never charged by banks 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 refers to interest on interest. The borrower must pay more interest. The interest is applied to both the principal and the accrued interest from previous periods. The bank assumes that the borrower owes the bank 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 principal loan amount, plus accrued interests from previous months. Both methods can be used to calculate interest for shorter periods of time. The difference between these two types of interest calculation grows as the lending period increases.
A personal loan calculator is a tool that can help you determine the best interest rate for you if you are looking to borrow money to pay personal expenses.
Different types of loans
There are many types of loans. There are many factors that can help to differentiate between the cost of loans and their contractual terms.
Secured vs. Unsecured Loan
Unsecured loans are available. Car loans and mortgages are secured loans because they are secured or backed by collateral. The collateral in these cases is the property that is being used to secure the loan. For example, a mortgage would be secured by the home while a car loan would be secured by the vehicle. If required, borrowers may need to provide additional collateral for secured loans.
Unsecured loans include credit cards and signature loan. They are not secured by collateral. Because of the higher risk of default, unsecured loans have higher interest rates that secured loans. Because the secured loan lender can take the collateral if the borrower defaults. Unsecured loans can have wildly different rates depending on many factors, including credit history.
Revolving vs. Term Loan
You can also refer to loans as revolving, or term. Revolving loans can be used, repaid and then spent again. A term loan is a loan that is paid in equal monthly payments over a specified period. A credit card is an unsecure, revolving credit loan. However, a home equity loan (HELOC), is a secured, repayable loan. A car loan is a secured term loan while a signature loan can be unsecured.
What is a loan shark?
Loan sharks are predatory lenders that offer informal loans at very high-interest rates to individuals with low credit and no collateral. These loan terms are not legally binding and loan sharks may resort to intimidation or violence to get their money back.
How can you reduce your total loan cost?
Paying more than the minimum monthly payment is the best way to lower your loan costs. You can reduce the interest you pay and eventually, the loan will be paid off early. However, some loans might have prepayment penalties.
How do you become a loan officer?
A bank employee responsible for the approval of mortgages, car loans, or other loans is called a loan officer. Every state has its own licensing requirements. However, the minimum requirement is 20 hours of pre-licensing classes.
Mortgage loan officers must also pass the NMLS National Test. They will also need to have a criminal background check and credit checks. Although there are fewer requirements for commercial loan officers, their employers might still require them to pass the NMLS National Test.
The bottom line
The financial economy is built on loans. Lenders can provide financing for economic activity by lending money with interest. They are compensated for their risk. Lending money is essential for modern economies, whether it’s small personal loans or large corporate debts.