What is a Loan? Definition and meaning
A loan is something that we have borrowed; usually in the form of money or property. We eventually pay back 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 principle.
The borrower pays the principle 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 principle 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).
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.
When the borrower agrees to pay a certain amount on specific dates, he or she has made a financial commitment.
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.
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.
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.
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, 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
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.
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.
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.