What is meant by a loan?
A loan is the amount of money that is borrowed by businesses or households to gain some monetary leverage. Loans are taken to plan more expensive purchases, the ones which may not be financed through regular incomes. These purchases include cars, property, houses, and other investments.
Loans are a liability; thus, the loaned amount needs to be returned along with interest within a given period. The conditions and repayments of a loan are agreed upon before the loan is given. Businesses or individuals may approach banks or financial institutions for a loan.
Most institutional lenders ask for collateral against which the loan is to be given. However, many financial institutions offer loans without any mortgage or collateral. The loaned amount may be given as a lumpsum amount or it can be released in portions spread over time.
How do loans work?
Secured loans are offered against a collateral, which acts as a security in case the borrower were to default in the future. All loans involve a rate of interest, which is an additional amount to be paid to the lender that is a percentage of the loaned amount.
Interest rates form a crucial part of taking loan. Interest payments may differ depending on the credit rating of the borrower. Most loans taken by businesses or households have a fixed rate of interest. This does not change even if the market interest rates do change. Some loans do offer variable rates, but they are not as popular. Repayments must be made monthly or can be made in a lumpsum manner.
What types of loans are there?
Loans can be of various types, some of these include:
What aspects are considered by financial institutions before giving out a loan?
There are 3 factors that may affect the creditworthiness of an individual or of a business. All these factors are crucial to lenders as it helps them avoid the scenario of a default on the loans they give out. These factors are:
What are the pros and cons of taking a loan?
Loans offer various advantages, the primary one being profit retention. Loans need not be shared with equity holders, unlike the funds received through equity. Investors must be repaid with profits in the future leading to a reduction in future profits. Loans allow an individual or a business to utilise the loaned amount themselves without having to share the profits.
However, loans have a disadvantage as well. Secured loans which offer a lower interest rates are often harder to procure. They come with a strict set of requirements, which many individuals might not be able to fulfil. Small business and individuals without any credit score might find it hard to meet the bank requirements.
Why are loans important for businesses?
Loans are accounted as a liability on the balance sheet of businesses. However, for the lender, a loan is an asset as it promises a future set of income for him. Moratoriums may be offered on loans under dire circumstances. However, certain banks and financial institutions may not be as accommodating.
When a loan remains unpaid for over one year then it becomes a long-term debt for the borrower. This could severely affect the credit score of a business, which could affect their loan eligibility in the future. If a business depends highly on loans for its functioning, then it would increase their liabilities.