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 or principal amount, along with interest or 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 are typically issued by corporations, financial institutions, and governments. Loans allow for growth in the overall money supply in an economy and open up competition by lending to new businesses. Loans also help existing companies expand their operations. 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. They can also take the form of bonds and certificates of deposit. It is possible to take 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 paid back.
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 or is disbursed. 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.
- A loan is when money or assets are given to another party in exchange for repayment of the loan principal amount plus interest.
- Loans with high interest rates have higher monthly payments—or take longer to pay off—versus low-rate loans.
- Loans can be secured by collateral such as a mortgage or 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.
Types of Loans
A number of factors can differentiate loans and affect their costs and 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.
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 on unsecured loans depending on multiple factors, including the borrower's credit history.
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 loans refer 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.
Special Considerations for Loans
Interest rates have a significant effect on loans and the ultimate cost to the borrower. 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.
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, 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 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 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.
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.