What is a Loan?

Published on: Wed, Sep 2, 2009

Classified as: Loans

A loan is a business contract in which lender agrees to give the borrower a certain sum of money with an expectation of getting the total amount back at a later date. The detailed terms of such a transaction are normally written down in the form of a promissory note or other type of contract. For example, the lender can demand some extra money over and above the original amount of loan. Original amount of loan is called principal and the extra amount demanded is called interest. In order to complete the transaction the borrower should agree to all the specifics of the contract including principal amount owed, interest rate applicable and dates when interest amount and principals become due. Due dates are important because, as per repayment terms lenders can assign penalties or fees for missed due dates i.e. late payments.

Who Applies for Loan?

Generally people avoid applying for loan because the institutionalized lenders like banks have started to include hidden fees and penalties in their contract documents. Excessive, complex and variable interest rates and financial charges and late fees are an example of what most of us have to bear after getting a loan from banks and other financial institutions.

Only people in face of large and expensive purchases (buying a home or a car) go for some sort of financial loan. Such loan can be a bank mortgage or it can be a private loan extended by the person or entity selling the item (i.e. car, home appliances etc.).

Student Loans

Students with limited resources, when going for higher education also apply for loans. For them however there are many government sponsored student loans available. Terms of these loans are normally very relaxed and vary low interest rates are charged. Interest rate on student loans is mostly fixed at the time of application and payback period is very long compared to other loans.

Difference between Gift and Loan.

Apparently loans and gifts seem very similar. Both involve person A giving money to person B so B can fulfill his immediate needs. There is a very vital legal distinction between a loan and a gift.

A very charitable family member or buddy may give you $3,000 for house maintenance, for example.

If the person giving you $3,000 does not expect to get back the money, It can be considered a gift. You can not be sued for repayment of such amount in any court of law.

But if the person giving you $3,000 explicitly declares the money as a loan and you pay him back even one cent, this money becomes a legal loan and the person lending it can request for and insist on repayment any time.

Most of the cases brought before Small claims courts are about determining whether a transaction was a gift or a loan.

For the reasons stated above it is very important to document all transactions and keep your paperwork even when making small private loans to friends or family.

Eligibility for a Bank Loan

Private loans can only satisfy people’s needs up to a limit. This is why, majority of loan applications are processed by banks or other lending institutions. Lenders as they are called, can not know each and every individual personally so they have devised a criteria or standard to establish a borrower’s financial position. Such criteria is known as credit score or credit rating. Loan applicant’s credit history is almost always the largest factor in deciding about eligibility for a certain type of loan. Other factors include but not limited to current income, assets and age. Purpose of loan is also key factor in lender’s decision to extend a loan. A loan given for buying a home is lot safer for bank than giving loan for opening a new fashion shop. Income to debt ratio is also very important. Such ratios tells the lender a lot about the ability of borrower to repay the loan with interest on time.

If you put it in words of a career banker…