What is a loan? What does it entail?

By Favour Ndime7 min read · Posted Apr 2, 2024

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Introduction

It is quite overwhelming when we have financial needs and concerns about our personal lives and businesses. There is either bankruptcy, the need to buy a house, an apartment, land, a car, start up a business, or expand an already existing business but the ends don’t seem to meet up. Well, some individuals may choose to get a loan to help navigate these financial hurdles.

With the right knowledge and understanding, navigating the world of loans becomes easier, allowing for more informed decisions and ease in achieving financial goals.

What is a loan?

Loans are not restricted to money alone; land, buildings, and machinery can also be loaned out. For the sake of simplicity, we will strictly consider financial loans in this article. A loan is defined as a sum of money one receives from an entity — generally a bank, person, or corporation with an agreement detailing a payment plan and interest requirements.

There are 4 main components to any loan agreement:

  1. Principal: The amount of money loaned or borrowed.
  2. Interest Rate: The percentage charged or paid for the money borrowed. It is usually expressed as an annual percentage rate (APR). For example, a 5% interest rate on a $1000 loan means that the borrower will pay $50 in interest over the course of a year.
  3. Date of Reimbursement: This is simply the date on which the principal and interest are being reimbursed (paid back). For example, a loan of €50 million is to be reimbursed monthly for the next 10 years).
  4. Term: The length of time a borrower takes to repay both the interest and loan. A loan that is expected to be paid back within a year is a short-term loan, while any longer than that is considered a long-term loan. It wholly depends on the industry involved (lender).

Sources of loans

  1. Banks and other financial institutions such as: credit unions, insurance companies, investment companies.
  2. Cooperative societies such as - credit unions
  3. Peer-to-peer lending

Types of loans

The realm of loans covers a range of options tailored to suit different needs and interests. Loans are of two major types:

Secured loans

The borrower pledges assets (e.g. property or vehicles) as collateral (guarantee) for the loan. These loans have lower interest rates. The assets are usually higher in value than the loan amount for security purposes.

Secured loans are divided into two:

  • Term Loan: These are loans with a fixed or flexible interest rate, as well as a fixed amount and repayment value.
  • Mortgage Loan: These are loans granted for the purchase of real estate (property) with an interest rate and repayment value. The property will only be given to the borrower when payment has been fully made; a default will lead to total seizure of the property. To this, the loan is secured by the property itself.

Unsecured loans:

The borrower does not pledge any asset as collateral (they are not secured by property). It comes with a higher interest rate as it is very risky for the lender.

Unsecured loans are divided into two:

  • Credit Card Loan: Is a type of loan that does not allow you to go through extensive documentation, except for paperwork to ensure your eligibility. Though credit scores can be affected. A bad credit will limit your ability to make purchases and gain trust from banks and other institutions in the future
  • Personal Loan: This is also referred to as a consumer loan. It is granted to individuals for different purposes such as debt consolidation to unexpected expenses. Banks and other financial institutions consider the borrower's credit history and personal income beforehand.

How does a loan work?

Borrowing Process

The borrowing process involves two parties: Borrower: A person that receives money from a lender. Lender: A bank or financial institution that lends money to individuals or corporations.

At the heart of every loan lies an agreement between the borrower and the lender, wherein the lender provides a specified sum of money/asset to the borrower with the expectation of repayment, usually with interest, over a specified period.

The loan process typically begins with the borrower submitting an application, which undergoes thorough evaluation by the lender to assess the borrower's creditworthiness and determine the terms of the loan. If the borrower is qualified, then the loan is approved but if otherwise, the application will be declined.

Terms And Conditions For Assessing Loans

These are general and specific requirements that form the basis of loan agreements. Lenders set their loan terms based on the total interest they'll earn over the life of a loan.

Some types of fees set by lenders are:

  • Application and Processing Fee: For the process of approving and administering a loan.
  • Origination Fee: This covers the cost of securing a loan (like mortgages)
  • Annual Fee: Is common for credit card loans. A fee you pay to the lender yearly.
  • Late Fee: For delayed reimbursement of loan.
  • Prepayment Fee: For paying off your loan before the loan payment is due. It is common for home, cars, etc. The prepayment fee is designed to compensate the bank (lender)for not receiving all the interest income they would have earned if you hadn't paid in time.

Note: Not all loans come with these fees, but you should look out for them and ask about them when considering a loan.

Factors affecting loan eligibility

When you want to get a loan for whatever financial needs you may have, there are criteria that must be considered. They are your:

  1. Income
  2. Credit Score: Is based on your credit history. It determines your creditworthiness for the loan. Typically, a credit score under 580 on a scale of 300 - 850 is considered to be a low credit score
  3. Employment Status
  4. Debt-to-Income Ratio: How much you earn versus what you spend
  5. Collateral (for secured loans)

Maintain good financial health, If you have a high credit record, you are more likely to get approved for loans and for better rates.

Collateral

Collateral are assets used to secure loans. They are basically physical items belonging to a borrower, which act as security for the loan. If the borrower is unable to pay the loan, the lender has a legal right to keep the collateral because of the agreement or contract.

Types of Collateral

Examples of collateral include consumer goods, equipment, farm products, inventory, and property on paper.

  1. Consumer goods are products purchased by any consumer, such as vehicles.
  2. Equipment are large and expensive machinery used in manufacturing businesses, construction, or government offices.
  3. Farm products include livestock and crops.
  4. Inventory consists of raw materials or work in progress.
  5. Property on paper includes stocks, bonds, and even funds held in a savings or checking account.

Risks and responsibilities of borrowing

While loans offer access to funds, they also come with risks and responsibilities for borrowers. The borrower is said to be discharged of all liabilities and the loan is considered repaid, when a borrower fulfills all the requirements of the loan agreement and repays the principal, interest and all charges on the loan. For secured loans, all collaterals pledged would be provided to the borrower. On a good note, when all terms and conditions are fulfilled, the lender would want to do business again with that borrower.

But when a borrower makes a default (not keeping to the loan agreements) in repayment. The following are consequences:

  • Damage to credit scores: A person or business is said to have a damaged credit score when they have a history of not paying their loans on time or they owe too much. With a bad credit score, you will find it difficult to receive loans from lenders.
  • Loss of collateral: When a borrower fails to keep to the loan agreement, the lender may be forced to take the assets placed as collateral for the loan. This becomes a great loss to the borrower.
  • Naming and Shaming: Is the act of saying publicly that a person or corporation has behaved in an appropriate or bad way. To this, lenders can drag borrowers name and personal details to the public to ensure compliance with the loan agreement.
  • Legal action by lenders: Lenders can sue borrowers to court when there is a breach in contract or loan agreement. Also, avoid taking loans from unauthorized lenders/personnel to avoid legal action against you. Always read the loan agreements carefully before you proceed.

Therefore, to be a responsible borrower, you must carefully evaluate the need for a loan, understand the terms and conditions, and maintain a sense of honesty with lenders. Also, ensure to prioritize loan repayment and budget accordingly to avoid financial difficulties.

Benefits of loans

Despite the potential risks, loans offer a multitude of benefits. Such as:

  • Providing a means for borrowers to establish a credit history or improve a credit score.
  • Enabling borrowers to address pressing needs, and pursue long-held aspirations.
  • Serving as catalysts for economic growth and innovation.
  • Loan fuels entrepreneurship
  • Improves investment, and progress across diverse industries and sectors.

Conclusion

Loans are an important component of modern finance, it provides individuals and corporations with the means to achieve their financial objectives. When borrowers fully understand the various aspects of loans, they can make informed decisions and effectively manage their debt. Borrowers should be on the lookout for the best borrowing practices to ensure success and smooth loan process, whether securing a personal loan for unexpected expenses or obtaining a mortgage loan to purchase a home. Be sure to choose the best offers that suit your preferences.

About The Author

Favour Ndime

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Comments

Lucas Moore · 2 months ago·

This article is broken down and organized really well!

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Our organization cannot give out official legal/fiscal guidance. All articles are written by volunteers and it may be beneficial to contact professionals to assist your understanding of the information and to guide your action. Pitch Labs bears no responsibility for the results of actions taken based off of article content or any other form of assistance given.