A loan occurs where one individual or company agrees to provide money to another individual or company, on the understanding that the other party (the borrower) will pay the money back, usually within a fixed time period. Where loans are provided in a commercial setting (such as by a bank), the borrower will also have to pay interest on top of the borrowed capital amount.
Let’s look then at some of the common elements that one would expect to see where a loan is agreed:
Loan provided subject to a risk assessment:
Banks, or other financial institutions, provide commercial loans in order to make money rather than out of the goodness of their hearts. A key element of this is trying to ensure that they only lend money to individuals or companies that are likely to be able to afford to repay the money within the stated timeframe (referred to as the term). Banks carry out this assessment of risk by collecting information about the borrower and then using this to conduct a credit score. The credit score assessment will then determine whether they are prepared to lend the money.
Loans not available to children:
Loans are a regulated financial product and one of the rules that lenders must adhere to is to ensure that they don’t grant loans to minors. The minimum allowed age may vary by country (subject to that country’s regulators) but is generally eighteen.
Loan entrenched in a legally binding agreement:
When you take out a loan with a lender, you are entering into a credit agreement. The lender agrees to provide the agreed sum of money and the borrower agrees to effect the required monthly repayments.
Loan provided subject to interest payments:
Sometimes the word “loan” is used where no interest payments are required. For example, you might decide to lend your brother $1,000 to help him pay off his credit card debt and you might agree with him that all he has to do is pay you back the capital sum over a set period. However, commercial loans, arranged with a bank, will always require the borrower to pay back the capital sum and some interest on top. The lender will justify this interest on the basis that they are enabling you to buy something now that you would otherwise not be able to, and they are taking on the risk that you might default on your repayments.
Loans generally have a fixed term for repayment:
I mentioned that the length of a loan is referred to as its term and it’s a general feature of commercial loans that the borrower will agree to pay the loan back within a set timeframe. For example, you might agree a car loan for $5,000 over three years. This helps distinguish them from an overdraft facility where you will have a set overdraft limit but no specific payback timeframe.
Repayment of loans will be by set monthly payment:
Another way that loans differ from other credit arrangements such as overdrafts or credit cards is that the borrower is required to pay a set sum each month and that repayment amount will come out of their bank account automatically by direct debit. The borrower then does not have the automatic option of varying the amount that they repay each month.
Different types of loans:
When we hear the word “loan” we tend to think only of the personal loans that individuals take out in order to purchase a car or holiday, etc. However, this is just one type of loan instrument that lenders offer. Mortgages are also classed as a loan although this is not always obvious to everyone. One important difference is that a mortgage is an example of a “secured loan”. When you take out the mortgage, you do so on the basis that if you default on payments the lender has the right to take ownership of your property. The mortgage loan is therefore said to be secured on the property.
Whilst we are most familiar with personal loans (such as your car loan or mortgage), they are also commonly used by small businesses and large companies. Banks, therefore, tend to sell a suite of loans that will cover the personal, business, and commercial sectors.
Loans can also have variable or fixed interest rates, and some may be capped which means that the lender agrees that the interest rate will not go above a pre-determined maximum level.
Having provided a pretty comprehensive overview of what a loan is, it’s worth finishing by reflecting on when a loan should be used. Loans are sometimes necessary where we need to purchase an item now but don’t have sufficient money available in our bank account. However, loans are a very expensive way of financing purchases, due to the interest element, and individuals and companies should therefore look to minimize the instances in which they need to employ them.