What is Loan?
A loan is a financial instrument used by persons and businesses to borrow money from authorized institutions, such as banks. The loan could also be a certain amount of money lent by one person to another with a consideration that the person receiving the loan will repay that amount in the future.
Many times, the issuer giving the loan charges some interest on the principal amount, and the person receiving the loan must pay the interest along with the principal amount.
Here, the issuer giving the loan is called a lender, and the person receiving the loan is known as a borrower.
Various factors like the income of the borrower, the credit score borrower, and past debts on the borrower are considered by the lender before giving a loan to the borrower. With such factors, lenders typically analyze or check the capability of the borrower to repay the loan. If the lender is not satisfied with the parameters mentioned above, then there are chances that the lender will not lend money to the borrower.
The loan can be in the form of a one-time payment of money, or it can also be lent in instalments. Similarly, the loan repayment can be made either in one go or in instalments. However, the repayment is often made in instalments with interest.
Loans can be of different types, such as secured, unsecured, personal, or commercial loans. The borrower needs to give some collateral as a mortgage to the lender, and sometimes no collateral is given in exchange for a loan by the borrower. An example of such an unsecured loan is a credit card.
If the lender is not satisfied with the credit score or income of the borrower, then the lender often puts high interest on the principal sum lent to the borrower.
Definition of a Loan
A loan is a type of debt that a person incurs from a lender, which could be any corporation, bank, or government. The lender provides a sum of money to the borrower, and in return, the borrower puts some collateral on the lender, and the borrower chooses the date of repayment.
The lender also applies the interest that he typically charges on the principal sum of money. The loan can also be in the form of certificates of deposits or bonds.
When a person needs money to start a business, construct a house, or for any other reason, the borrower may reach some financial institutions or any corporation and apply for a loan.
To get a loan from the entities mentioned earlier, the borrower must furnish some information like why he is taking the loan, his financial history, Social Security Number (SSN), and other required documents.
After the borrower submits all the documents and the information to the respective institution, the given information is analyzed to check whether the person applying for the loan can repay the loan. To do so, the debt-to-income ratio of the borrower is checked. After analyzing the given information, the creditor decides whether to give the borrower a loan.
Suppose the lender is not satisfied enough to give a loan and rejects the application of the person seeking the loan. In that case, the creditor must give a reason for rejecting the application to the borrower.
In contrast, if in case the creditor is satisfied with the details provided by the borrower, then he may agree to give a loan to the borrower. After this, the borrower and the creditor enter into an agreement in which all the terms and conditions are mentioned, and both parties must sign the contract.
The loan agreement mentions all the details, like the date of repayment of the debt, the interest charged on the loan, and other necessary details. If the lender wants some collateral of the borrower to keep as a security for the repayment of the loan, then he must mention it in the loan agreement. For example, a deed of property owned by a borrower can be kept as collateral.
Uses of Loans
The loan is taken for many purposes. It could be taken to make any purchase, for the expansion of the business, to start a business, or even for educational purposes.
The loans and the interest charged are the primary income source for financial institutions.
Components of Loans
The following are some important components of a loan:
Also, if the borrower does not repay the loan within the term mentioned in the agreement, the creditor can charge extra interest on the principal amount for the delay in the payment.
Tips on getting a Loan
While applying for the loan, a borrower must know the criteria on which the lender will evaluate the borrower's capability to repay the loan.
Convincing the creditor to give a loan is not easy, as the creditor checks all the credentials and capabilities of the borrower before accepting the application for a loan.
Following are the given factors which a lender considers to check whether he should take the risk of giving a loan to the borrower or not:
The first and most important factor which largely affects the lender's decision is the borrower's income.
In the case in which the loan amount is big, it is very important for the lender to check whether the income of the borrower is enough to repay the loan and the borrower will not face any difficulty in the repayment of the loan.
If the loan is a home loan, in such a case, the stable employment of the borrower plays a deciding role in the grant of the loan by the lender.
The second most important factor which should be considered before lending the loan amount to the borrower is the borrower's credit score.
A credit score is a numerical representation that reflects the creditworthiness of a person. The credit score depends upon past borrowing and repayment of the loan by the person.
If the person applying for the loan has a good credit score, then it becomes a plus factor for the borrower to get a loan. The credit score is affected by past missed payments on the loan, and even bankruptcy can lower the credit score.
A bad credit score reflects a bad image of the person in the lender's view, and the chances of the rejection of the loan application increase.
The lenders check not only the income of the borrower and his stable employment, but the lenders also consider the number of active loans that a borrower has taken. The high number of active loans represents that the borrower is facing difficulties in the repayment of such active loans, and therefore the lenders hesitate to lend the borrower another loan as they feel that it could be risky as the borrower is already in a lot of debt.
In order to increase the chances of your loan application being accepted, you must convince the lender that the money they are lending is going to be used by the borrower responsibly.
The borrower should also pay the loans and credit card regularly and should avoid incurring unnecessary debts. It is possible for the borrower to get a loan even with a bad credit score and a high number of other debts, but the lenders often charge a high-interest rate for such approved loans.
Types of Loans
There are different types of loans, and here we will discuss all of them one by one:
1. Secured Loan
Secured loans are loans that are backed by some security or collateral as security. Mortgages and car loans are the types of secured loans.
In such cases, the asset for which the borrower is taking the loan is kept as collateral to the creditors. For example, if the loan is a home loan, then the home will become collateral. In another case, if the loan is being taken to purchase a car, then the car becomes collateral. The borrower can get his collateral registered completely in his name only after all the loans have been repaid.
2. Unsecured Loan
An unsecured loan is the opposite of a secured loan, as no collateral is kept as a security to the creditor. Some examples of unsecured loans are credit cards and signature loans.
As the risk of default in the cases of unsecured loans is higher than the secured loan, the lender often charges a higher interest rate on such loans. This is because if the borrower makes any default in the repayment of a secured loan, then in such a case, the creditor can repossess the collateral, but this option is not available to the lender of an unsecured loan.
3. Revolving Loan
A revolving loan is a loan that the borrower can spend, repay and spend again. The revolving loan can be further divided into two types, i.e., secured revolving loan and unsecured revolving loan. A credit card is the best example of an unsecured revolving loan, whereas a home equity line of credit is the best example of a secured revolving loan.
4. Term Loan
A term loan is a type of loan which the borrower pays up in the form of monthly instalments for a fixed period of time. This, too, can be further divided into a secured term loan and an unsecured term loan. An example of a secured term loan is a car loan, and an example of an unsecured term loan is a signature loan.
Relationship between Interest Rates and Loans
If the loan amount is big, then in such a case, the interest rate is also charged higher than the interest rate charged on a small loan.
A loan with a high-interest rate also increases the monthly payment amount that a borrower needs to pay to the creditor.
For example, suppose a person takes a loan of $5000, and the term of the loan is of five years. If the interest that the creditor charges on such a loan is 4.5%, then the debtor is required to pay $93.22 dollar as a monthly payment. Still, in the same situation, if the interest rate that is charged on the principal amount is 9%, then the monthly payment amount increases to $103.79.
The loan can be given at a fixed interest rate as well as at a fluctuating interest rate, depending on the contract entered into between the parties. It will also take a longer time to pay the loan if the interest rate is high.
Simple vs Compound Interest
Two types of interest rates could be charged on the principal amount. They are simple interest and compound interest.
It is important to note that a bank never charges simple interest on the loan that it gives to the borrowers. Simple interest is the interest that is charged on the principal loan amount.
Let us understand it clearly with a simple example. Suppose there is a person who takes a loan from a bank and the amount which is borrowed, i.e., principal amount, is $300000, and in the loan agreement which is made between the borrower and the bank, the interest rate which is mentioned is 15% per annum.
In this case, the total amount, including the interest that the borrower needs to pay to the bank, will be $300000* 1.15, which equals $345000. However, as stated above, banks do not follow the practice of this loan type, i.e., the loan with simple interest.
Unlike simple interest, which is charged on the principal amount, compound interest is the interest that is charged on the interest itself, in addition to the principal amount. In simple terms, it means that the lender charges interest not only on the principal amount but on the total interest that was charged on the principal amount in previous periods.
It means that if the bank is charging compound interest on the principal amount at the end of the first year, then the bank assumes that the borrower owes them the principal amount along with the accumulated interest in the first year. In the second year, the bank assumes that the borrower owes them the principal amount, the interest charged in the first year and also the interest charged on interest (for the first year).
Therefore, in cases where the lender charges compound interest on the loan, the total interest charged on the principal amount becomes higher as compared to that if the lender charges simple interest on the principal amount. For shorter periods, the calculation for both types can be done in a similar way. But, it is not suggested for longer period loans as the disparity grows accordingly.
If someone plans to take a loan for personal expenses, then a personal loan calculator can be used to check which interest rate is suitable for you. There are many loan calculator tools present on online portals.
What is the best way to reduce the total loan cost?
One of the best ways to reduce the total loan cost is to pay the lump sum of the payment as much as possible, more than the minimum payment if possible. This will ultimately reduce the required loan amount and total interest which is going to be charged on the loan. Also, in such a way, the borrower will be able to pay his loan early and save himself from paying interest for a longer period.
How can someone become a loan officer?
The loan officer is the one who approves the mortgage, car loan, and other loans. In order to become a loan officer, each state has its own requirements for licensure that must be passed by an individual. The standard requirement to get the license to become a loan officer is at least 20 hours of pre-licensing classes.
Also, the mortgage officers are required to pass a test named NMLS national test, and the criminal background of the mortgage officers is also checked before granting the license to them.
The Bottom Line
Loan plays a very important role in the life of an individual, businessman, or even a company. Some of the most common loans that individuals take include home loans, car loans, and education loans.
The concept of a loan is beneficial not only for the persons who are taking the loan but also for the lenders as they get interested in return for the risk they take for giving money to the borrowers. It is also said that loan acts as a building block for the financial economy.