In its essence, the word ‘loan’ refers to borrowing any particular object by a person or a collective from another to return it within a stipulated amount of time. This word has a more specific connotation in the banking and financial sector.
Here, a loan refers to the borrowing of money by one party from another for a certain period, after which this money has to be returned with interest. This is finalized after a certain mode of payment is decided upon (whether in installments or all at once), and collateral is provided by the borrower as a kind of security in case they cannot pay back on time. This, however, may not always be the case.
- A loan is a financial transaction where a lender provides money to a borrower with the expectation of repayment, with interest.
- Loans can be secured, meaning they are backed by collateral or unsecured, where any collateral does not back them.
- Loans are commonly used for personal, business, or investment purposes and are essential to the economy.
Different components of a loan
A loan may be of various kinds and for different purposes – house, student, credit, personal, business, and so on. It depends largely on the bank in question and the country’s financial system. However, these are some of the typical aspects involved in the taking of a loan:
- The loaning authority will first ensure whether the borrower has justified causes for taking a loan and the ability to repay it.
- Interest will always be charged on the principal amount of the loan, so the amount repaid will always be greater than the amount initially borrowed.
- Loans must often be taken out against a mortgage or collateral to ensure that the loaning authority is secure because of the inability to repay.
- The repayment is made in installments; missing any installment can lead to penalization.
- The tenure of any loan depends on a variety of factors. The interest charged may be simple or compounded annually, or both, through the tenure.
Advantages of a loan
- A loan from financial institutions with fixed low rates enables entrepreneurs to take risks, which will benefit both the business and the economy in the long run.
- Loans can help tide over crises.
- Loans can also be taken to fulfill educational, housing, and other essential progress-related needs.
Disadvantages of a loan
- The collateral necessary for a loan makes it a risky venture wherein the borrower often stands to lose an essential asset necessary to sustain life, such as their house.
- Banks in rural areas suffer the most because peasants often cannot pay their debts. This is the cause of distress not only to the borrower but repeated occurrences of this nature may financially harm a bank beyond repair.
- The idea of paying back in fixed installments or EMIs is unpleasant to several small-scale and new businesses, which makes them resort to borrowing money from loan sharks.
- Prioritization and allocation of personal funds become essential when taking out a loan, which may not be easy for those taking loans for a shorter period.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.