In this day and age, ‘loan’ is a term used quite frequently in almost all aspects of life. Loans have become a day-to-day tool for most of us as a means of bridging a gap between actual income and desired income.

Definition of a ‘Loan’

In finance, a loan can be defined as a lending of money by one or more individuals, organizations, banks, or other institutions to other party or parties (borrower).

In pre-bank times, a wealthy individual used to be the main lender in a village or a city. However, the concept grew out to be more regulated and standardized to become banks and financial institutions.

The main incentive for the lender to lend out money to other parties is the interest that he collects on the money loaned. Usually, the interest will be a % of the money loaned (principal). This interest cost also compensates the lender for the loss of value of money with time due to inflation.

A loan is given out for a specific period of time, within which, the borrower may have to pay back interest continually, usually every month.

The borrower may also have the option to pay back the principal amount in small portions, thus gaining the possibility to reduce the interest cost on the loan.

Due to the presence of several variables factoring into the lending and borrowing process, the governments of countries have strict rules to regulate the entire process through institutions such as banks and financial institutions.

Main Types of Loans

Secured Vs Unsecured Loans

Loans can be given out either secured or unsecured. A secured loan is a loan backed up against an asset of the borrower. In the case of a default of the loan by the borrower, the bank or the financial institution will have the right to possess the secured asset.

An unsecured loan is a loan that is not backed up against an asset of the borrower. The bank or the financial institution takes a bigger risk in such a loan than of a secured loan. Usually, such loans are given out to borrowers with a good borrowing history. As compensation, the lender could increase the interest rate on the loan.

Fixed Loans Vs Variable Loans

Fixed Loans or Fixed Rate Loans are loans issued with a pre-determined fixed interest rate. The loan agreement will state the rate of interest to be borne by the borrower in advance and will not change throughout the agreement period. The lender can change the interest rate in the case of a renegotiation of the loan terms, should that happen.

Variable Loans or Variable Rate Loans are loans issued with a condition for a fluctuating interest rate. The rate will most likely will be fetched from the market interest rate. However, there will be a floor rate and a ceiling rate which will restrict the movement of the rate between these two limits, to prevent large variations in the interest rates favoring or abusing both the borrower and the lender.

Categories of Loans

There are many different categories of loans catering to different needs of borrowers. However, essentially, the same principle of the loan process underlines all these categories of loans.

Personal Loan

Possibly, the most popular type of loan is a personal loan. A personal loan can be obtained for consumption, investment, purchase of a car, purchase of a house, renovations, education, etc. Hence, a personal loan can be categorized as following;

• Auto loan
• House loan/mortgage
• Education/student loan
• Payday loan
• Credit card

Due to their popularity, personal loans are highly regulated by banks and financial institutions. A comprehensive evaluation of the borrower will be done before money is loaned out. Factors such as monthly or annual income, disposable income, other loan commitments, individual credit score, and loan repayability of the borrower will be evaluated.

Corporate Loan

A loan obtained by a corporate or a business is known as a corporate loan. The same principles of a personal loan applies in a corporate loan as well. However, there could be some differentiating features when it comes to the execution of a corporate loan.

The lender will evaluate the credit rating/history of the business before proceeding with the loan. The lender can evaluate the corporate earnings, profits, corporate credit structure, business history, and future business forecasts to base the lending decision.

Depending on the outcomes of the above evaluations, the lender may opt to go for a secured or an unsecured loan, and the same principles as above apply in either case.

If in case the loan amount is significantly large, the lender may partner up with another lending institution to undertake the risk.

In some cases, the lenders may opt not to receive repayment in cash. Instead of loan repayment, the lender may prefer to convert the loan into a part of the capital/equity structure of the company thus becoming an investor/owner of the company.

National Loans

The same principles of lending and borrowing money happening between governments of countries or by international organizations to governments of countries are known as National Loans.

Several international organizations that provide loans for developing countries are International Monetary Fund (IMF), World Bank (WB), Asian Development Bank (ADB), African Development Bank (AfDB), and so on.

Countries such as China, Japan, and Germany are some of the biggest lending nations in the world whereas countries such as the United States, the United Kingdom, and Netherlands are some of the biggest debtors in the world.