Loan

A loan is a financial arrangement in which one party borrows a sum of money from another party with the agreement to repay it over time, typically with interest
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Updated on Jun 24, 2024
Reading time 4 minutes

3 key takeaways:

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  • A loan is a sum of money borrowed that must be repaid with interest.
  • Loans can be secured or unsecured, affecting the interest rates and terms.
  • Loans are used for various purposes, including personal, business, and mortgage financing.

What is a loan?

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A loan is a financial arrangement in which one party borrows a sum of money from another party with the agreement to repay it over time, typically with interest. Loans are a fundamental part of personal and business finance, allowing individuals and companies to make large purchases or investments that they cannot afford upfront.

Types of loans

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Loans come in various forms, each designed to meet different financial needs. The main types include:

Secured loans

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Secured loans are backed by collateral, such as a house or car. This collateral reduces the lender’s risk, often resulting in lower interest rates. Common examples of secured loans are mortgages and auto loans. If the borrower defaults, the lender can seize the collateral to recover the loss.

Unsecured loans

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Unsecured loans do not require collateral and are based on the borrower’s creditworthiness. These loans typically have higher interest rates due to the increased risk to the lender. Examples include personal loans and credit card debt. Because there is no asset backing the loan, the lender relies on the borrower’s promise to repay.

Fixed-rate loans

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Fixed-rate loans have an interest rate that remains the same throughout the loan term. This predictability allows borrowers to budget their repayments without worrying about fluctuating interest rates. Mortgages and student loans often come with fixed rates.

Variable-rate loans

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Variable-rate loans have interest rates that can change over time, usually in relation to an underlying benchmark or index. These loans may start with lower interest rates but can increase, potentially making repayments more expensive. Home equity lines of credit (HELOCs) often have variable rates.

How does a loan work?

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The process of obtaining a loan typically involves several steps:

  1. Application: The borrower applies for a loan by providing financial information to the lender. This includes income, credit history, and details of the loan purpose.
  2. Approval: The lender reviews the application and decides whether to approve the loan based on the borrower’s creditworthiness and ability to repay.
  3. Agreement: If approved, the borrower and lender sign a loan agreement outlining the loan amount, interest rate, repayment schedule, and any other terms.
  4. Disbursement: The lender provides the loan amount to the borrower, who can then use the funds as needed.
  5. Repayment: The borrower makes regular payments over the loan term, covering both the principal and interest. Once all payments are made, the loan is considered repaid in full.

Uses of loans

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Loans are used for various purposes, including:

  • Personal expenses: Such as consolidating debt, covering medical bills, or funding major purchases like appliances or vacations.
  • Business needs: Including starting a new business, expanding operations, or purchasing equipment.
  • Education: Financing college or vocational training through student loans.
  • Real estate: Buying a home or investment property through mortgages.

Benefits of taking a loan

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Taking a loan offers several advantages:

  • Access to large sums of money: Loans enable significant purchases or investments that might otherwise be unaffordable.
  • Improved credit score: Successfully repaying a loan can enhance the borrower’s credit rating.
  • Flexible use: Loans can be tailored for various needs, from personal expenses to business investments.

Risks associated with loans

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While loans offer benefits, they also come with risks:

  • Debt burden: Borrowers must manage repayment obligations, which can strain finances if not handled properly.
  • Interest costs: Borrowing money incurs interest, increasing the total repayment amount.
  • Credit impact: Failing to repay a loan can damage the borrower’s credit score and lead to legal consequences.
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  • Credit score management
  • Personal finance planning
  • Mortgage options and advice
  • Business financing strategies
  • Debt consolidation methods

Sources & references

Arti

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...