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Loan
A loan is a type of debt. This
article focuses exclusively on monetary loans, although, in practice,
any material object might be lent. Like all debt instruments, a loan
entails the redistribution of financial assets over time, between the
lender and the borrower.
It is commonly believed that the borrower initially receives an amount
of money from the lender, to be paid back, usually but not always in
regular installments, to the lender. In fact, the lender, whether a bank
or credit card company, does not provide any cash to the borrower, but
simply extends “credit.” The lender does this by making a credit entry
into the financial account (e.g. savings or checking) of the borrower;
the value of this credit is equal to the amount of the loan. At the same
time, the bank, for example, marks the loan as a liability in one part
of their accounting system, and an asset in another part. The amount of
the asset is equal to the amount of money the borrower promises to pay
back, known as the principal.
In this way, the bank or other lending institution creates money, which
the borrower is now free to “spend.”
In addition to the principal, the lending institution generally charges
the borrower a fee, referred to as interest on the debt, for the
privilege of using this newly-created money. Note that the lender acts
merely as an intermediary between the borrower and the party providing
the goods or services that the borrower obtains with her loan money. The
lender is not required to, and typically does not, furnish any tangible
assets such as cash money.
In essence, the lending institution creates money out of thin air, by
accounting entries, and makes a substantial profit in the process. For
example, if the interest on the loan is 6 percent, to be paid off in 30
years (a typical home mortgage contract), the borrower will end up
paying more than double the amount of the loan. If the contract is for a
loan of $100,000, the borrower at the end of the contract period will
have paid back $ 215,838. The lender’s profit is greater than the
original loan amount.
A loan is of the annuity type if the amount paid periodically (for
paying off and interest together) is fixed.
A borrower may be subject to certain restrictions known as loan
covenants under the terms of the loan.
Acting as a provider of loans is one of the principal tasks for
financial institutions. For other institutions, issuing of debt
contracts such as bonds is a typical source of funding.
Legally, a loan is a contractual promise between two parties where one
party, the creditor, agrees to provide a sum of money to a debtor, who
promises to return the money to the creditor either in one lump sum or
in parts over a fixed period in time. This agreement may include
providing additional payments of rental charges on the funds advanced to
the debtor for the time the funds are in the hands of the debtor
(interest).
Types of loans
Secured
A secured loan is a loan in which the borrower pledges some asset (e.g.
a car or property) as collateral for the loan.
A mortgage loan is a very common type of debt instrument, used by many
individuals to purchase housing. In this arrangement, the money is used
to purchase the property. The financial institution, however, is given
security — a lien on the title to the house — until the mortgage is paid
off in full. If the borrower defaults on the loan, the bank would have
the legal right to repossess the house and sell it, to recover sums
owing to it.
In some instances, a loan taken out to purchase a new or used car may be
secured by the car, in much the same way as a mortgage is secured by
housing. The duration of the loan period is considerably shorter — often
corresponding to the useful life of the car. There are two types of auto
loans, direct and indirect. A direct auto loan is where a bank gives the
loan directly to a consumer. An indirect auto loan is where a car
dealership acts as an intermediary between the bank or financial
institution and the consumer.
A type of loan especially used in limited partnership agreements is the
recourse note.
A stock hedge loan is a special type of securities lending whereby the
stock of a borrower is hedged by the lender against loss, using options
or other hedging strategies to reduce lender risk.
A pre-settlement loan is a non-recourse debt, this is when a monetary
loan is given based on the merit and awardable amount in a lawsuit case.
Only certain types of lawsuit cases are eligible for a pre-settlement
loan.[citation needed] This is considered a secured non-recourse debt
due to the fact if the case reaches a verdict in favor of the defendant
the loan is forgiven.
Unsecured
Unsecured loans are monetary loans that are not secured against the
borrowers assets. These may be available from financial institutions
under many different guises or marketing packages:
credit card debt
personal loans
bank overdrafts
credit facilities or lines of credit
corporate bonds
The interest rates applicable to these different forms may vary
depending on the lender and the borrower. These may or may not be
regulated by law. In the United Kingdom, when applied to individuals,
these may come under the Consumer Credit Act 1974.
Demand
Demand loans are short term loans that are atypical in that they do not
have fixed dates for repayment and carry a floating interest rate which
varies according to the prime rate. They can be "called" for repayment
by the lending institution at any time. Demand loans may be unsecured or
secured.
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