What Is a Loan?
A loan is a form of debt incurred by an individual or other entity. The lender—usually a corporation, financial institution, or government—advances a sum of money to the borrower. In return, the borrower agrees to a certain set of terms including any finance charges, interest, repayment date, and other conditions. In some cases, the lender may require collateral to secure the loan and ensure repayment. Loans may also take the form of bonds and certificates of deposit (CDs).
The term loan refers to a type of credit vehicle in which a sum of money is lent to another party in exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest and/or finance charges to the principal value which the borrower must repay in addition to the principal balance. Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms including secured, unsecured, commercial, and personal loans.
How The Loan Process Work
Here’s how the loan process works. When someone needs money, they apply for a loan from a bank, corporation, government, or other entity. The borrower may be required to provide specific details such as the reason for the loan, their financial history, Social Security Number (SSN), and other information.
The lender reviews the information including a person’s debt-to-income (DTI) ratio to see if the loan can be paid back. Based on the applicant’s creditworthiness, the lender either denies or approves the application. The lender must provide a reason should the loan application be denied.
If the application is approved, both parties sign a contract that outlines the details of the agreement. The lender advances the proceeds of the loan, after which the borrower must repay the amount including any additional charges such as interest.
The terms of a loan are agreed to by each party before any money or property changes hands or is disbursed. If the lender requires collateral, the lender outlines this 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.
Loans are advanced for a number of reasons including major purchases, investing, renovations, debt consolidation, and business ventures. Loans also help existing companies expand their operations.
Loans allow for growth in the overall money supply in an economy and open up competition by lending to new businesses. 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.
Type Of Loan
Loans come in many different forms. There are a number of factors that can differentiate the costs associated with them along with their contractual 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. In these cases, the collateral is the asset for which the loan is taken out, so the collateral for a mortgage is the home, while the vehicle secures a car loan. Borrowers may be required to put up other forms of collateral for other types of secured loans if required.
Credit cards and signature loans are unsecured loans. This means they are not backed by any collateral. Unsecured loans usually have higher interest rates than secured loans because the risk of default is higher than secured loans. That’s because the lender of a secured loan can repossess the collateral if the borrower defaults. Rates tend to vary wildly on unsecured loans depending on multiple factors including the borrower’s credit history.
Revolving vs. Term Loan
Loans can also be described as revolving or term. A revolving loan can be spent, repaid, and spent again, while a term loan refers 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.