What is a Loan?
A loan is a sum of money that one or more individuals or companies borrow from banks or other financial institutions so as to financially manage planned or unplanned events. In doing so, the borrower incurs a debt, which he has to pay back with interest and within a given period of time.
The borrower and the lender need to come to an agreement on the loan terms before any money is exchanged. Sometimes, the lender asks the borrower to provide an asset as collateral, which will be specified in the loan agreement. A typical loan for families in America is a mortgage, which is used to buy a home.
Loans can be provided to people, businesses, and even governments. The primary reason for taking out a loan is to obtain money to increase one’s financial resources. The interest and fees act as income for the lender.
Types of Loans
Loans can be classified further into secured and unsecured, open-end and closed-end, and conventional types.
1. Secured and Unsecured Loans
A secured loan is one that has some kind of collateral backing it up. For example, many banks and financial institutions ask borrowers to show their title deeds or other proof of ownership of an asset until the loans are completely paid off. Other things that can be used as collateral include stocks, bonds, and personal belongings. People usually go for secured loans when they need to borrow a large amount of money. Since lenders are generally hesitant to lend big sums without collateral, they keep the borrowers' assets as a guarantee.
Some typical features of secured loans are lower interest rates, strict borrowing limits, and longer repayment terms. Common examples of secured loans are mortgages, boat loans, and auto loans.
On the other hand, an unsecured loan is one where the borrower doesn’t need to provide any asset as collateral. For unsecured loans, lenders carefully evaluate the borrower’s financial situation. This helps them determine the borrower’s ability to repay and decide if they should grant the loan. Unsecured loans include things like credit card purchases, education loans, and personal loans.
2. Open-End and Closed-End Loans
A loan can be classified as either closed-end or open-end.
In the case of an open-ended loan, a person can borrow repeatedly. Credit cards and lines of credit are great examples of open-ended loans, even though they come with credit limits. A credit limit refers to the maximum amount of money that can be borrowed at any time.
Depending on what someone needs financially, they might decide to use all or just part of their credit limit. Each time this person makes a purchase with their credit card, the amount of available credit goes down.
On the other hand, closed-end loans do not allow individuals to borrow again until they have fully paid them off. As repayments are made on a closed-end loan, the outstanding balance goes down. However, if the borrower needs additional funds, they must apply for a new loan from the beginning. This process involves submitting documents to show they are credit-worthy and waiting for approval. Mortgages, auto loans, and student loans are examples of closed-end loans.
3. Conventional Loans
The term is often used when applying for a mortgage. It refers to a loan that is not insured by government agencies such as the Rural Housing Service (RHS).
Things to Consider Before Applying for a Loan
For individuals planning to apply for loans, there are a few things they should first look into. They include:
1. Credit Score and Credit History
If someone has a solid credit score and a good history, it indicates to the lender that they can make timely repayments. Therefore, the better the credit score, the greater the chances of getting a loan approved. With a strong credit score, a person also has a higher likelihood of receiving favorable loan terms.
2. Income
Before applying for any type of loan, another factor that a person should consider is their income. For employees, they will need to provide pay stubs, W-2 forms, and a salary letter from their employer. On the other hand, if the applicant is self-employed, they only need to submit their tax returns from the past two years and any relevant invoices.
3. Monthly Obligations
Besides their income, it’s also important for a loan applicant to assess their monthly obligations. For example, someone might earn $6,000 a month but have monthly obligations of $5,500. Lenders may hesitate to approve loans for such individuals. This is why most lenders require applicants to detail all their monthly expenses, including rent and utility bills.
Final Word
A loan is a sum of money that an individual or company borrows from a lender. It can be classified into three main categories, namely, unsecured and secured, conventional, and open-end and closed-end loans. However, regardless of the loan that one chooses to apply for, there are a few things that he should first assess, such as his monthly income, expenses, and credit history.
Additional Resources
Thank you for reading CFI’s guide to Loans. To keep learning and advancing your career, the following CFI resources will be helpful:
