- 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.
- A loan may be secured by collateral such as a mortgage or it may be unsecured such as a credit card.
- 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.
Characteristics of loan
- Time to maturity. Time to maturity describes the length of the loan contract. Loans are classified according to their maturity into short-term debt, intermediate-term debt, and long-term debt. Revolving credit and perpetual debt have no fixed date for retirement. Banks provide revolving credit through extension of a line of credit. Brokerage firms supply margin credit for qualified customers on certain securities. In these cases, the borrower constantly turns over the line of credit by paying it down and reborrowing the funds when needed. A perpetual loan requires only regular interest payments. The borrower, who usually issued such debt through a registered offering, determines the timing of the debt retirement.
- Repayment Schedule. Payments may be required at the end of the contract or at set intervals, usually on a monthly or semi-annual basis. The payment is generally comprised of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, or repaid little by little until it is completely retired. As the principal balance diminishes, the interest on the remaining balance also declines. Interest-only loans do not pay down the principal. The borrower pays interest on the principal loan amount and is expected to retire the principal at the end of the contract through a balloon payment or through refinancing.
- Interest. Interest is the cost of borrowing money. The interest rate charged by lending institutions must be sufficient to cover operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of 3, 5, and 10 years. Floating rates are tied to some market index and are adjusted regularly.
- Security. Assets pledged as security against loan loss are known as collateral. Credit backed by collateral is secured. In many cases, the asset purchased by the loan often serves as the only collateral. In other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land collateralize mortgages. Unsecured debt relies on the earning power of the borrower.