What is a Loan? Definition and meaning
A loan is defined as something that is borrowed (usually in the form of money or property) that is eventually paid back to the lender with interest. It is a form of credit.
It can be for a one-time amount or in the form of open-ended credit (with a set limit).
When someone borrows money, the amount they borrow is called the principle.
The principle is paid back by the borrower to the lender in the form of installments (which can be specified in the contract).
A loan is something borrowed.
The interest paid annually on the amount borrowed is known as APR (annual percentage rate).
A loan contract typically specifies:
- the principle amount (how much someone wants to borrow).
- the interest rate on the loan (the cost borrowing).
- the repayment date (when the loan has to be repaid by).
According to ft.com/lexicon, a loan is:
“Money lent (i.e. provided by a lender to a borrower), normally in return for interest and repayable at a specific date. Also, the act of lending something, especially money.”
There are five general types of loans: secured, unsecured, demand, subsidized, and soft loans.
These are secured by an asset – which is called the collateral. If the borrower fails to make his or her repayments the bank reserves the right to take possession of the collateral.
Examples of secure loans include: a mortgage, auto finance, a home equity line of credit (HELOC), or a home equity loan (where the home is used as collateral).
These are not secured by assets – in the the case of a default, the lender will not have automatic access to an asset. For the bank, unsecured lending is riskier, hence the interest rates are generally quite high.
Examples of unsecured loans include: credit cards, a student loans, personal lines of credit, and personal loans.
These have a floating interest rate, and have no specific maturity date. However, the lender has the right to demand a repayment at any time – usually this happens when they predict the customer is going to run into financial problems.
This type of lending is arranged when the lender has a significant level of confidence that the borrower will be able to pay off the debt within a short amount of time.
These are loans in which the government agrees to pay the interest. With a Stafford loan, for example, the government pays the interest as long as you are at school.
These loans have relatively lenient terms and conditions, with lower interest rates than the average market rate. They are normally provided by government agencies as opposed to banks or financial institutions. For example, the World Bank often provides soft loans to help develop projects in developing countries.
Wet and dry loans
A wet loan is a mortgage loan in which the funds are released early – before all the paperwork is completed. This type of loan is useful if the borrower needs to act swiftly, as is usually the case in a ‘sellers’ market’.
A dry loan is the opposite – the money is not released until all the documentation regarding the loan is completed, checked, and signed by all parties concerned.
Loan payment formula (example):
One of the most common loan payment types is the the fully amortizing payment, where a loan is paid off with regular or periodic installments.
Formula to calculate the fixed monthly payment:
P = fixed monthly payment
L = the loan amount
n = the number of months
c = the monthly interest rate
How do banks evaluate a loan application?
When banks are evaluating whether or not a person or business is eligible for borrowing, they check the credit worthiness of the applicant using a formula called the six C’s of credit.
– Character – lenders need to believe they are lending to a reliable borrower.
– Capacity – checking the borrower’s ability to repay the loan.
– Capital – the borrower’s own personal investment in what they will be using the loan for.
– Collateral – items that can be sold if a borrower fails to repay the amount borrowed.
– Conditions – what the applicant wants the money for.
– Confidence – a bank needs to feel confident with the borrower.