Loan Basics

What is a loan?

A loan is a debt vehicle in which one party provides a sum of money to the borrowing party in exchange for future repayment of that principal. Oftentimes, a loan is accompanied by a stream of payments paid in intervals by the borrower to the lender, over the duration of the loan period – this series of payments is referred to as interest. Interest can be thought of as a rental fee on money.

Below are two common types of loans:

  1. 1.
    Secured Debt: A loan is considered ‘secured’ if the advanced money is backed by collateral. Collateral is an asset containing a level of resellable value given to the lender in the event of the borrower’s inability to service a loan or its interest payments. Putting up collateral for borrowed money reduces the risk of loss for the lender. Car loans are a secured debt agreement. Failure to meet agreed-upon principal + interest payments would result in the car being taken away from the borrower and resold by the lender.
  2. 2.
    Revolving Term Loan: Loans can vary by the frequency in which a borrower can access money. Receiving the one-time principal amount up-front is considered a ‘term’ loan. On the other hand, a ‘revolving’ loan allows a borrower to receive money whenever they need to – until they reach a pre-determined limit. Credit Cards are a form of revolving term loans. Account-holders are afforded the flexibility on the amount and frequency of using credit, and at the end of the month, pay the principal balance + interest to keep the line of credit available.

How interest payments are determined and why this rate varies by loan type and prospective borrower:

Again, interest is the amount a creditor charges a borrower for the use of advanced money. From the borrower’s perspective, interest is the cost of borrowing. The interest rate charged is a percentage of the principal loan which differs depending on several factors touched on below.
The interest rate required for a loan is determined by the level of risk associated with the borrower’s ability to repay the principal loan amount. A low-risk borrower possesses the ability to consistently generate a surplus of cash (cash net of existing obligations) – think of an individual with a steady, high-paying job accumulating disposable income and having a strong record of meeting prior debt obligations. Low-risk borrowers receive lower interest rates because lenders feel confident that advanced money or assets will be repaid in full. In light of this, high-risk borrowers offer the risk-tolerant lender more attractive interest payments for use of their money. The lender may be inclined to accept the heightened risk if they believe that the borrower’s financial circumstances or future ability to repay will improve having received the loan. An example would be a modestly performing business receiving a loan to build a factory in order to produce and sell more products. There is uncertainty risk associated with lending money to build a factory that has yet to produce and sell a single good, let alone enough to meet regular interest payments in addition to the principle. Before extending capital to the business, the investor must analyze the loan and borrower.
The lender's understanding of how the use of funds will be used to increase the likelihood of loan repayment is a consideration among other determinants, which is not limited to the following:
  1. 1.
    The length and type of loan
  2. 2.
    Whether a loan is secured or unsecured (not backed by collateral)
  3. 3.
    The level of interest that prospective borrowers are willing to accept and pay in the broader loan market
  4. 4.
    Provisions or guarantees assured to the lender in the event of insolvency (see Defaulting on a Loan)