A loan is something that we have borrowed; usually in the form of money or property. We eventually pay back the loan 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.
When someone borrows money, we call the amount they borrow the principal.
The borrower pays the principal back in regular payments, i.e., in installments. The contract specifies when to make the payments and how much they should be.
The interest that the borrowers pay annually on the amount they borrowed is the APR. APR stands for annual percentage rate.
What do loans specify?
- The principal amount (how much someone wants to borrow),
- the interest rate on the loan (the cost borrowing), and
- the repayment date (when to repay the money by).
5 main types of loans
There are five general types of loans: secured, unsecured, demand, subsidized, and soft loans.
When the borrower agrees to pay a certain amount on specific dates, he or she has made a financial commitment.
Secured loans
These are secured by an asset, i.e., collateral. If the borrower fails to make his or her repayments the bank may take possession of the collateral.
Examples of secure loans include a mortgage, auto finance, or a home equity line of credit (HELOC). Also, home equity loans because the parties use the home as collateral.
Unsecured loans
These are not secured by assets. If there is a default, the lender will not have automatic access to an asset.
For the bank, unsecured lending is riskier. Hence, interest rates are generally quite high.
Examples of unsecured loans include credit cards, student loans, and personal lines of credit. Personal loans also tend to have no collateral.
Demand loans
These have a floating interest rate and have no specific maturity date. However, the lender has the right to demand repayment at any time.
This usually happens when they predict that 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 rapidly.
Subsidized loans
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.
Soft loans
These loans have relatively lenient terms and conditions, i.e., lower interest rates than the average market rate.
Government agencies typically provide them rather than banks or financial institutions.
For example, the World Bank often provides soft loans to help develop projects in developing countries.
Wet and dry loans
Wet
A wet loan is a mortgage loan in which the lender releases the funds early. The lender releases the money before the parties have completed the paperwork.
This type of loan is useful if the borrower needs to act swiftly. In a ‘sellers’ market,’ for example, things can move very fast.
Dry
A dry loan is the opposite. The lender does not release the money until all the documentation regarding the loan is completed, checked, and signed by all parties concerned.
Guaranteed loans
Young people and relatives
If a young person needs to borrow money, but they have a low credit rating, they may ask a parent or relative to act as guarantor. If they cannot repay the loan, i.e., if they default, the relative will make sure the loan is pain back.
We call this type of loan a guaranteed loan.
Individuals and government
Sometimes, the government is the guarantor, as occurs in the US with some loans for veterans and in the UK’s ‘Help to Buy’ program.
Companies and government
During the 2007/8 global financial crisis, the Great Recession that followed, and the COVID-19 pandemic, many state-guaranteed loans were arranged for major corporations. Some of them may not have survived without those guaranteed loans. In the US and UK, the number of bankruptcies in 2020 (during the Pandemic) actually decreased, thanks to government help.
There was much debate about the level of financial help companies received.
Loan payment formula (example)
One of the most common loan payment types is 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?
Banks determine a potential borrowers creditworthiness by using a formula we call ‘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 the lender can sell if the borrower fails to repay.
- Conditions – what the applicant wants the money for.
- Confidence – a bank needs to feel confident with the borrower.
A loan is a type of debt. Most US lenders use the FICO Score when determining whether to approve an application.
Banks and others
There are many places you can get money from if you need a loan. Examples include banks, credit unions, online lenders, peer-to-peer lenders, friends or family, pawn shops, HELOC (home equity lines of credit), government programs, and microfinance institutions.
Beware of borrowing from individual moneylenders who operate alone; these can be ‘loan sharks’. Loan sharks tend to charge exorbitant interest rates and may employ intimidating tactics if you are unable to pay back on time.