Loans

Almost everyone is familiar with this term in one way or another. In simple language, a loan is the lending of money from one entity to another. This entity can be a person, a company or an entire government of a country.

How does a loan exactly work?

Its a pretty simple mechanism. Taking a loan involves two entities, a borrower and a lender. The borrower takes a loan from the lender, and while doing so, the borrower makes a commitment to the lender that they will repay the borrowed amount (principal) along with some extra money (interest) over a fixed period of time. Once the borrower returns the principal amount along with the interest, the transaction is said to be settled. The terms and conditions of each loan are defined in a contract provided by the lender.

What if the borrower is unable to repay the loan?

Now this is where the types of loans come into play. Broadly speaking, there are two categories of loans, secured and unsecured loans.

Secured Loans

Secured loans are backed by a collateral. What does that mean? Simple, it means that after taking a loan from the lender, if the borrower is unable to repay the loan within the fixed period, the lender would obtain legal rights to possess any one of their assets (property, car, etc.) and recover the money.

Unsecured Loans

Unsecured loans are not backed by collateral. In this case, the lender just decides to be nice to the borrower and simply trusts them to repay the loan. There's more risk involved on the lenders side since a borrower may not repay the amount. The interest rate for unsecured loans is always higher than that for secured loans.
However, if you fail to repay and unsecured loan, the lender has the right to report the debt to the major credit reporting agencies which will affect your credit score. The lender can also send your account to collections or file a lawsuit to collect the money owed.

How does the lender decide the amount to loan?

The more a borrower is creditworthy the more comfortable the lenders will feel to lend them money. A creditworthy borrower has two things, the ability to repay and collateral. Having a lot of income in relation to ones debt increases ones ability to repay. In the event that one cannot repay, one would have valuable assets to use as collateral which can be sold.

The borrowers creditworthiness plays a  huge role in the interest rate offered. If the borrower has a good credit score, the lender will have more peace of mind that the borrower will repay the loan, and offer them a lower interest rate or maybe a larger amount of money. If the borrower has a lower credit score they might want to build their score up before submitting a loan application to see a better loan offer.

Now how to build a good credit score? Answering that would be going a bit off-topic here since this post mostly includes basic information on loans only. Instead I would recommend the readers to go through the article: How to build good credit? which I personally found to be very informative of the different ways of building good credit.

Types of Loans

The common types of loans that people apply for are:

1. Home Loan (secured)
2. Car Loan (secured)
3. Education Loan (unsecured)
4. Personal Loan (unsecured)
5. Business Loan (may be secured or unsecured)
6. Gold Loan (secured)

Disclaimer:

1) This blog post provides personal finance educational information, and it is not intended to provide legal, financial, tax or any type of official advice.

2) None of the images used in this post are owned by me. They belong to their respective copyright holders.