Edited byAlfina
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Loan?

A loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment. The borrower has to pay back the initial amount (principal balance) with an additional amount (interest), the rate of which varies in each case.

Sometimes, the borrower has to present collateral to gain the lender’s trust. While loans provide essential financial assistance to the borrower for a certain time period, they act as an investment opportunity for the buyer to secure a future set of cash flows for a return.

how loan works

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Key Takeaways

  • A loan is a sum of money a lending entity gives to a borrowing entity which it repays after a specific period, usually with an interest.
  • They are a huge part of our financial markets and are availabe in many forms like a secured, unsecured, conventional, open-ended and close-ended loan, etc.
  • Loans generate a future set of cash flows that result in return for the lender
  • There are a few advantages and disadvantages of lending and borrowing loans.

How does a Loan Work?

Loans can be given or taken by individuals, institutions, or governments. Typically, a borrower looking for capital (big or small, personal or for finance) seeks out a commercial lender or a family friend who can offer it. The lender will advance an amount of money to the borrower to agree to the lender’s terms. 

In addition to the loan amount, there will be a set of terms including any fees, interest, and the structure of interest. i.e, if the interest is paid a little each month, it is known as amortization. Or if it is paid before the principal balance is paid at the end, it is an interest-only loan).

The lending documents and contract will outline all terms before disbursing any money. Usually, though not always, lenders will have some type of asset as collateral for the money they are lending out. This is to mitigate any risk that the borrower defaults and leaves the lender with no money and no way to get it back. Both the lender and the borrower must agree to all the terms.

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Here is an example:

Let’s consider a real estate investment company trying to buy an apartment building for 100 million dollars. First, they would need to apply for a loan from a bank (or any other lending entity). Their application will include information about the business owners, the business itself, and the opportunity. Then, the lender will likely underwrite the deal themselves. They would go out to the property and assess its (and the company’s) creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new more

The lender will offer a loan for a certain percentage of the property (called the loan to value ratioLoan To Value RatioThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in more). The interest rate on an apartment community is usually based on prevailing interest rates (LIBOR for now) plus a spreadSpreadSpread is the price, interest rate, or yield differentials of stocks, bonds, futures contracts, options, and currency pairs of related more or return on top of the market interest rate. In this case, the loan will be for 200bps (basis pointsBasis PointsBasis points or BPS is the smallest unit of bonds, notes and other financial instruments. BPS determines the slightest change in interest rate, to be precise. One basis point equals 1/100th part of more that are 1/100 of 1 percentage, so 2%) plus LIBOR. The LIBOR at the time of this writing is 0.13 but changes drastically based on economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among more.

So, in this case, the interest rate is currently 2.13%. Another fee the lender requires is an application fee of $1,000 and an originationOriginationOrigination in finance refers to the borrower applying for a loan or mortgage and getting it approved by the more fee of 1 point (a whole percent) of the lending amount. The lender has told the company that they will issue out a sum of $65,000,000, which would be a 65% LTV ratio, so the origination fee will be $650,000. 

The final terms are that it is an IO loan, meaning the company pays the only interest during the hold and then the principal balance in totality at the end of the term. As real estate investors, the borrowers can simply pay off the money when they sell the asset at the end of the hold period. It frees up their capital so that they can either give it back to investors or invest it into a property to improve the asset during the hold period, which is a huge benefit to leverage.

Types of Loans

 There are endless variations and structures to loans, just like there are for mergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for more. A few big types are secured, unsecured, conventional, open-ended, and close-ended. 

Secured loan:

A secured loanSecured LoanSecured loans refer to the type of loans approved and received against a guarantee or collateral. If they fail to do so, the lending institution acquires the collateral to compensate for the amount that the borrowers were more often has collateral like in the case of a car loan (they can repossess the car if you do not make the payments). 

Unsecured loan:

An unsecured loanUnsecured LoanAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more has no recourse besides legal action for the lender to get their money back (this would be like consumer credit card debt where the lender does not have anything in return for the credit card in the wallet, and they cannot put a lien on the person’s house to mitigate the risk of nonpayment). 

Conventional loan:

A conventional loan is a common type of mortgage plan for homeowners that the government does not insure, subsidize or guarantee. Other lending types that assist homebuyers in the form of lower down paymentsDown PaymentsDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more, lower rates, or insurances would be FHA and VA loans. 

Open-ended loans:

Open-ended loans do not have any prepayment penalties,Prepayment Penalties,The prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment more whereas close-ended ones do. Typically one can pay back an open-ended loan early with no problem (such as getting a 30-year loan for the apartment building in the example above but selling the asset in 10 years).

Close-ended loans:

Close-ended loans will have a large fee, such as a percentage point or two if a person pays early or outside the agreed-upon time frame for payments.



Frequently Asked Questions (FAQs)

How do loans work?

Loans are sums of money credited to a borrower who has to repay it in a specific period, usually with an additional amount called interest. Its types and interest rates can vary according to different situations.

Does a loan affect credit score?

It can affect a person’s credit score if they are due to be paid for a long time. Similarly, the number of times they have borrowed money also affects their credit rating. This will make it harder for the person to obtain a new loan without paying back the existing ones. On the other hand, a prompt person who pays back the sum or interest regularly can improve their credit rating.

Are loans considered income?

Income is strictly the money that a person earns. Since loans are not earned and are repayable, they are not classified as income. They, therefore are also not taxable. 

This has been a guide to Loan & its definition. Learn how loans work, the types, advantages, and disadvantages along with an example. You can learn more about the form the following articles –