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Loans: An Introduction
How Do Loans Work?
Simply put, a loan is a transaction where a lender transfers something of worth to a person or company that intend to pay the lender back with interest. The loan is made official by a binding written contract that assures the lender of the borrowers obligations and vice versa. Most any sort of material can be loaned, but the most common loan currency is, of course, legal tender. Money can be loaned for widely varying lengths of time -- one day, one month, one year, even 30 years. As a rule of thumb, the longer the repayment period, the higher the interest rate will be -- to protect the lender from inflation and to compensate him for his risk. As part of the loan, a repayment schedule -- usually monthly -- will be established. If the borrower fails to keep to this schedule then he risks defaulting on the loan and being exposed legally to the lenders remedy options. The original amount of the loan must be repaid in order to relieve the borrower of his debt. This amount is called the principle of the loan. The amount over and above the principal, or the cost of the loan if you will, is said to be the interest.
Loan Categories
Two major categories encompass almost every loan: secured and unsecured. Both are equally common, but work differently for the borrower and the lender. Smaller loans for varying expenses will generally be unsecured, whereas larger loans, such as home mortgages and business loans will fall into the secured category. Unsecured loans carry with them a higher risk, and generally higher interest rates, whereas secured loans tend to behave in a mostly opposite fashion. In the next part of this article, we'll explore each category further.
Loan Type: Secured
A secure loan, is, simply, a debt backed by the collateral on the borrower's end. The most common type of secured loan is a home mortgage. The lender gives the borrower money to purchase the deed to a home. The buyer then repays the lender on a monthly basis. If the buyer fails to meet his repayment obligations, the lender is protected. He can "foreclose" on the deed to the home and take possession of it. Since the lender's risk is thus ameliorated a secured loans interest rate will often be lower than that of an unsecured loan. Other types of secure loans are automobile loans, business loans, secured personal loans, and home equity loans.
Loan Type: Unsecured
In an unsecured loan transaction, the borrower will gain access to the lender's money without any sort of collateral. Instead, the loan will be extended on the borrower's projected ability to pay the loan back and his or her credit standing. Example of unsecured loans include credit cards, unsecured personal loans, payday loans, and student loans. (Although student loans are underwritten (i.e. secured) by the federal government, enabling lower interest rates. If the borrower defaults on an unsecured loan, his immediate assets may be protected, but his credit rating will plummet along with his ability to obtain future credit -- secured or unsecured.
Unsecured Loans: Buyer Beware
When entering into an unsecured loan arrangement, be sure to establish the interest rate and fees upfront. They can often be quite steep and noncompetitive with other options that might be available.
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