A loan is a type of consumer financial product. It is an agreement in which a lender extends an amount of money or credit to a borrower that must be repaid by a predefined future date. This structure is known as closed-end credit.

The purpose of loans is to fund the purchase of an asset or to fund a major purchase. By using a loan, borrowers can make a large purchase for which they do not have enough cash and pay for it over time. The exception is credit builder loans, whose purpose is to improve consumer credit profiles.

Loans are not the same as revolving credit, in which the lender extends a reusable amount of money or credit that the borrower can use and repay continually without a fixed repayment date.

Loans are also not the same as accounts. A loan is an agreement, usually written, whereas an account is a ledger that documents cash distributions and receipts between the loan borrower and lender. In other words, the loan is a consensus but the account is the justification.

Summary

Variations

A loan is a category in which there are several variations. Each variation is defined by its purpose.

Purpose

The purpose of a loan is to make a purchase that the buyer otherwise would not have enough cash (also known as liquidity) to make. Loans facilitate the purchase and sale of large assets and expensive services in an economy.

Structure

Loans are structured using a combination of eight (8) or fewer properties, including

Principal Amount

The principal amount is the numeric value of money or credit the lender extends to the borrower.

Term

The loan term is the defined period of time in which the borrower must repay the principal amount.

Payment Terms

The payment terms, or specifications, are the frequency of payments required. Most modern consumer loans require monthly payments, but some allow a single payment in the final term, often called a "bullet" payment.

Installment loans are those with payments on a regular basis, usually months.

Interest

Interest is the price that the lender charges to extend the principal amount to the borrower. it represents a percent calculated on the outstanding principal amount over time.

Interest is composed of two components. The first is price, and the second is risk. Price is a fixed rate, but risk can change based on the borrower.

For example, a loan may have a fixed interest component of 5% charges to all borrowers, and a variable 0% - 5% based on consumer creditworthiness. It's interest range is therefore 5% to 10%.

The risk component is what consumers can control by improving their credit profile.

Fees

Fees are non-interest costs of a loan related to administration and processing. The most common loan fee is called origination and refers to a absolute or fixed rate applied at the start of the loan, usually 5%.

Origination fee is deducted from the principal amount at the start of the loan, but the borrower pays interest on the agreed principal amount.

For example, imagine a $100 loan with a 1% monthly interest rate and 5% origination fee. The borrower received $95 at he start of the loan ($100 - [5% * $100]) but pays $1 in interest the first month (1% * $100).

Annual Percentage Rate (APR)

Annual percentage rate is the relative amount of all interest and other fees charged as a percent of the loan principal over a 365 day period. APR standardizes the cost of loans so consumers can compare across lenders.

For example, imagine two loans for $100 at 10% interest. The first is 12-months and the second is 24-months. The 12-month loan total interest is $76, which equates to an APR of 6%. The 24-month loan has total interest of $167, which equates to an APR of 14%.

They both have the same interest rate, but the APR on the second is higher because that interest is paid over twice as many periods.

Inversely, APR can be deceptive. Imagine again a 12-month for $100 and 24-month loan for $200. Both of these loans have an APR of 6%, but the 24-month loan has total interest of $152 versus only $76 on the 12-month loan. This occurs because the principal amount is different.

The image below illustrates this dynamic.

Grace Period

A grace period is a number of days in which no interest is charged on due payments not yet settled. For example, some loans have a grace period of 24 hours on the due date to allow for delays in money transfers. Grace periods are more common on revolving credit and not as common on closed-end credit.

Collateral

Collateral is an asset the borrower pledges to forfeit in the case s/he defaults on the loan. Collateral mitigates risk to lenders because rather than the decisive threat of never recovering their principal amount, they can lose it but confiscate an asset to sell.

Because collateral mitigates risk, it decreases the risk component of interest cost. Borrowers save money by pledging collateral.

It's critical to note that predatory lending practices such as title loans and pawn loans retain high interest rates despite collateral because they target borrowers whose creditworthiness is too low to have an alternative (such as a bank).

We advice borrowers avoid title and pawn loans, as well as payday loans, except in emergency situations.

Types

At the most fundamental level, loans exist in two types. The first is secured, and the second is unsecured. In a sentence, secured loans are backed by collateral whereas unsecured loans are not.

Secured

Secured loans are backed by collateral. Examples include mortgages, auto loans, title loans, savings-secured loans, credit builder loans, pawnshop loans. Because of collateral, secured loans generally have lower interest rates than their unsecured counterparts.

Unsecured

Unsecured loans are not backed by collateral. Examples include personal loans and student loans. Because they are not backed by collateral, unsecured usually have higher interest rates than their secured counterparts.

Recourse

Recourse is a lender's right to pursue assets outside the scope of the loan agreement in the case the borrower defaults on the loan. It is similar to the right to repossess collateral in a secured loan in that the lender can recover an asset, but different because it requires additional legal steps not usually governed by the lease agreement.

Recourse on secured loans (such as mortgages) is common in status but rare in practice because lenders go to great lengths to clearly denominate the value of the collateral. Moreover, when borrowers default on a loan it is typically due to unavailability of other assets to sell.

Unsecured loans, however, frequently include recourse.

Renegotiation

Renegotiation is a lender option to change the terms of the loan during its life in order to increase the likelihood of borrower payments.

For example, a mortgage borrower that loses his job may request temporary forbearance or lower interest until he obtains a new position.

Forbearance puts the loan on hold and ensures the lender recovers its money with a small delay rather than go through an expensive foreclosure process.

How to Get

Conceptually, a loan works by providing money to a borrower that must be repaid before a predefined date, either in installments or in one-shot.

Concretely, the process in involves 9 steps, shown below.

The borrower now has the asset (or purchased good), which she could not have gotten without the loan. She is also now debt free.

Parties Involved

Every loan agreement consists of at least one lender and at least one borrower.

Lender

The lender is the party that provides the principal amount and charges interest. Though rare, it is possible to have two lenders in a loan agreement.

Dual-lender loans are usually the result of complex financial engineering in business settings and rarely occur in the consumer space. The reason is that it's simply uncommon for a lender to lack the funds to finance a single consumer.

Borrower

The borrower is the party that receives the principal amount and must reimburse it before the predefined date, usually in installments. It is uncommon for two unrelated borrowers the co-borrow on a loan agreement, but married couples often sign large loan agreements such as mortgages together.

Moreover, a loan agreement can include borrower and cosigner. The cosigner is a party that guarantees the loan will be paid in case the primary borrower defaults. The cosigner effectively assumes the risk for the lender but does not reap the benefits of ownership over the asset or purchase funded. Common examples of cosigners are parents on student loan agreements.

Target Markets

Loans are an integral part of nearly every modern economy. Even communist governments such as Cuba have national debt. In other words, the target market for loans is every country on Earth.

Consumer loans are particularly important in Anglo-Saxon countries such as Australia, Canada, the UK, and the United States, as well as continental Europe.