In its essence the word ‘loan’ refers to the borrowing of any particular object by a person or a collective from another with the intent of returning it within a stipulated amount of time. In the banking and financial sector, this word has a more specific connotation.
Here, a loan refers to the borrowing of money by one party from another for a certain period of time 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 a collateral is provided by the borrower as a kind of security in case they are unable to pay back on time. This however may not always be the case.
Different components of a loan
A loan may be of various kinds and for different purposes – house loans, student loans, credit loans, personal loans, business loans – and the list goes on. It depends largely on the bank in question and the financial system of the country. However, these are some of the typical aspects involved in the taking of a loan:
- The loaning authority in question will first ensure whether the borrower has justified causes of 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 have to be often taken out against a mortgage or collateral to ensure that the loaning authority is secure on the account of inability of repayment.
- The repayment is usually done in installments and 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 crisis situations.
- 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 for the sustenance of life, such as their house.
- Banks in rural areas suffer the most because peasants are often unable to pay their debt. This is 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 becomes essential when taking out a loan, which may not be easy for those who are taking loans for a shorter period of time.