How Do Loans Really Work?

A loan is a debt instrument. It is a financial transaction between a borrower and a lender. A borrower asks the lender for a certain amount of money, which is called the principal. The money borrowed is fully repaid in partial payments over time, and these partial payments are called installments. The loan comes at a cost, which is called the interest on the loan. In effect, the lender does not give away the money but sells it and makes a profit. The loan may also be protected by a legal contract, which outlines the terms and restrictions of the debt.

Generally, the most common types of loan transactions are from:

• A person who offers to assist a friend or relative. A private loan is an informal arrangement between two people. A lender provides assistance in a personal emergency or to help secure an investment opportunity. Usually little or no interest is charged and no legal contract drawn up.

• A wealthy individual to an entrepreneur. An Angel investment is a business laon for the purpose of funding a new or existing business.

• A financial institution to an individual. These are the most typical and cover all kinds of financial institutions from banks to credit card companies.

• A citizen to a government. These loans are known as bonds. Bonds can also be issued by a federal agency, municipality, or corporation.

When a financial institution makes a loan, these loans are divided into private loans and commercial loans.

Personal Loans

Personal loans are those made to an individual. Personal loans include payday loans, installment loans, car loans, mortgages loans, credit cards, and home equity lines of credit. These loans are based on credit scores and the interest rates of the type of loan (APR). Although monthly payments can be reduced by choosing a longer payment period, this will also result in an increase in the overall interest payments.

Commercial Loans

Commercial loans are similar in structure to personal loans, but also include corporate bonds and commercial mortgages. Whereas underwriting for personal loans is based on credit scores, for businesses, it is based on credit rating.

Types of Loans

There are numerous types of loans like a secured loan, a subsidized loan, an unsubsidized loan, a mortgage loan, a recourse note, a stock hedge loan, a pre-settlement loan, an unsecured loan, a demand loan.

A Secured Loan

This is a loan where the borrower has to secure the amount of money borrowed with some property to reduce the lender’s risk. This security is known as collateral. For instance, for a private loan, an individual may offer a car or a house as collateral. If the borrower defaults, the lender has the legal right to sell the collateral to recover the money loaned.

A Subsidized Loan

This is a loan that will not gain interest until it is used. This is the typical structure for college loans made to students.

An Unsubsidized Loan

This is a loan that will gain interest from the time it’s disbursed.

A Mortgage Loan

This is a loan that is used to buy a house or property. The financial institution has a lien on the title of the house as a form of security. If the owner does not make payments as agreed, defaulting on the loan, the bank has the legal right to repossess the house and sell it to recover the money.

An auto loan for the purchase of either a new or a used car is structured in a similar way. However, this is a short loan and extends to the useful life of the car. It can also be either a direct or an indirect loan. A direct loan is one made by the bank to the car buyer while an indirect loan is one where the car dealership is an intermediary between the bank and the car buyer.

A Recourse Note

This is a loan applicable to limited partnership agreements.

A Stock Hedge Loan

This is a loan used in the financial markets. The lender hedges a borrower’s stock to reduce risk.

A Pre-settlement Loan

This is a loan that is based on the amount that may be awarded in a lawsuit. Only specific types of lawsuits are considered eligible for a pre-settlement loan, and this loan is considered a non-recourse loan because it is forgiven if the court decides in the defendant’s favor.

An Unsecured Loan

This is a loan that is best known by the general public because of a variety of marketing packages used to promote it. An unsecured loan includes credit cards, personal loans, bank overdrafts, and lines of credit. Some corporate bonds are unsecured, others secured. Similarly, demand loans may be either unsecured or secured.

A Demand Loan

This is an atypical short-term loan. There is no specified date for repayment. Since the interest rate is based on the prime rate, it’s considered a “floating” interest. The lender can call in the loan at any time.

Interest Rates on Loan Repayments

The interest rates may be decided between the borrower and the lender; they may also be regulated by law.

The most common payment type is an amortization, in which the monthly rate is the same over time.

There are different ways interest can be calculated on a loan.

If the loan is a simple interest one for a year, the formula is interest divided by principal. Thus, if the interest is $60 and the principle is $1000, then the interest is 6%. Interest/principal. $60/$100=6%.

If the loan is for less than a year, the formula is interest divided by principal, multiplied by days in the year, divided by days of the loan. Thus, if the interest is $60 and the principle is $1000 and the loan is for 120 days then the interest is 18%. Interest/principal times 360 days in the year/days of the loan. $60/$1000 x 360/120=18%. Note: a financial year is 360 days, not the 365.25 days in the calendar.

If the loan is a discounted one, the formula is interest divided by principal, minus interest, multiplied by days in the year, divided by the days of the loan. Thus, if the interest is $60 and the principle is $1000 and the loan is for 360 days then the interest is 6.38%. Interest/principal minus interest times 360 days in the year/days of the loan. $60/$1000 - $60 x 360/360=6.38%.