Loan

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Loan document issued by the Bank of Petrevene, Bulgaria, in 1936. Petrevene 18.jpg
Loan document issued by the Bank of Petrevene, Bulgaria, in 1936.

In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that debt until it is repaid as well as to repay the principal amount borrowed.

Contents

The document evidencing the debt (e.g., a promissory note) will normally specify, among other things, the principal amount of money borrowed, the interest rate the lender is charging, and the date of repayment. A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower.

The interest provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants. Although this article focuses on monetary loans, in practice, any material object might be lent.

Acting as a provider of loans is one of the main activities of financial institutions such as banks and credit card companies. For other institutions, issuing of debt contracts such as bonds is a typical source of funding.

Personal loan

Secured

A secured loan is a loan in which the borrower pledges some asset (e.g., a car or house) as collateral.

A mortgage loan is a very common type of loan, used by many individuals to purchase residential property. The lender, usually a financial institution, is given security  a lien on the title to the property  until the mortgage is paid off in full. In the case of home loans, if the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.

Similarly, a loan taken out to buy a car may be secured by the car. The duration of the loan is much shorter  often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. In a direct auto loan, a bank lends the money directly to a consumer. In an indirect auto loan, a car dealership (or a connected company) acts as an intermediary between the bank or financial institution and the consumer.

Other forms of secured loans include loans against securities - such as shares, mutual funds, bonds, etc. This particular instrument issues customers a line of credit based on the quality of the securities pledged. Gold loans are issued to customers after evaluating the quantity and quality of gold in the items pledged. Corporate entities can also take out secured lending by pledging the company's assets, including the company itself. The interest rates for secured loans are usually lower than those of unsecured loans. Usually, the lending institution employs people (on a roll or on a contract basis) to evaluate the quality of pledged collateral before sanctioning the loan.

Unsecured

Unsecured loans are monetary loans that are not secured against the borrower's assets. These may be available from financial institutions under many different guises or marketing packages:

The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.

Interest rates on unsecured loans are nearly always higher than for secured loans because an unsecured lender's options for recourse against the borrower in the event of default are severely limited, subjecting the lender to higher risk compared to that encountered for a secured loan. An unsecured lender must sue the borrower, obtain a money judgment for breach of contract, and then pursue execution of the judgment against the borrower's unencumbered assets (that is, the ones not already pledged to secured lenders). In insolvency proceedings, secured lenders traditionally have priority over unsecured lenders when a court divides up the borrower's assets. Thus, a higher interest rate reflects the additional risk that in the event of insolvency, the debt may be uncollectible.

Demand

Demand loans are short-term loans [1] that typically do not have fixed dates for repayment. Instead, demand loans carry a floating interest rate, which varies according to the prime lending rate or other defined contract terms. Demand loans can be "called" for repayment by the lending institution at any time. Demand loans may be unsecured or secured.

Subsidized

A subsidized loan is a loan on which the interest is reduced by an explicit or hidden subsidy. In the context of college loans in the United States, it refers to a loan on which no interest is accrued while a student remains enrolled in education. [2]

Concessional

A concessional loan, sometimes called a "soft loan", is granted on terms substantially more generous than market loans either through below-market interest rates, by grace periods, or a combination of both. [3] Such loans may be made by foreign governments to developing countries or may be offered to employees of lending institutions as an employee benefit (sometimes called a perk).

Target markets

Loans can also be subcategorized according to whether the debtor is an individual person (consumer) or a business.

Personal

Common personal loans include mortgage loans, car loans, home equity lines of credit, credit cards, installment loans, and payday loans. The credit score of the borrower is a major component in and underwriting and interest rates (APR) of these loans. The monthly payments of personal loans can be decreased by selecting longer payment terms, but overall interest paid increases as well. [4] A personal loan can be obtained from banks, alternative (non-bank) lenders, online loan providers and private lenders.

Commercial

Loans to businesses are similar to the above but also include commercial mortgages and corporate bonds. Underwriting is not based upon credit score but rather credit rating.

Loan payment

The most typical loan payment type is the fully amortizing payment in which each monthly rate has the same value over time. [5]

The fixed monthly payment P for a loan of L for n months and a monthly interest rate c is:

For more information, see monthly amortized loan or mortgage payments.

Abuses in lending

Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over him or her; subprime mortgage-lending [6] and payday-lending [7] are two examples, where the moneylender is not authorized or regulated, the lender could be considered a loan shark.

Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures, the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by consumer organizations of lending at usurious interest rates and making money out of frivolous "extra charges". [8]

Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.

United States taxes

Most of the basic rules governing how loans are handled for tax purposes in the United States are codified by both Congress (the Internal Revenue Code) and the Treasury Department (Treasury Regulations  another set of rules that interpret the Internal Revenue Code). [9] :111

1. A loan is not gross income to the borrower. [9] :111 Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth. [9] :111 [10]

2. The lender may not deduct (from own gross income) the amount of the loan. [9] :111 The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment). [9] :111 Deductions are not typically available when an outlay serves to create a new or different asset. [9] :111

3. The amount paid to satisfy the loan obligation is not deductible (from own gross income) by the borrower. [9] :111

4. Repayment of the loan is not gross income to the lender. [9] :111 In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender. [9] :111

5. Interest paid to the lender is included in the lender's gross income. [9] :111 [11] Interest paid represents compensation for the use of the lender's money or property and thus represents profit or an accession to wealth to the lender. [9] :111 Interest income can be attributed to lenders even if the lender doesn't charge a minimum amount of interest. [9] :112

6. Interest paid to the lender may be deductible by the borrower. [9] :111 In general, interest paid in connection with the borrower's business activity is deductible, while interest paid on personal loans are not deductible. [9] :111The major exception here is interest paid on a home mortgage. [9] :111

Income from discharge of indebtedness

Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness. [9] :111 [12] Thus, if a debt is discharged, then the borrower essentially has received income equal to the amount of the indebtedness. The Internal Revenue Code lists "Income from Discharge of Indebtedness" in Section 61(a)(12) as a source of gross income.

Example: X owes Y $50,000. If Y discharges the indebtedness, then X no longer owes Y $50,000. For purposes of calculating income, this is treated the same way as if Y gave X $50,000.

For a more detailed description of the "discharge of indebtedness", look at Section 108 (Cancellation of Debt (COD) Income) of the Internal Revenue Code. [13] [14]

See also

US specific:

Related Research Articles

Debt deferred payment, or series of payments, that is owed in the future

Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

Debenture Debt instrument

In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest. Although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Senior debentures get paid before subordinate debentures, and there are varying rates of risk and payoff for these categories.

Debt consolidation form of debt refinancing that entails taking out one loan to pay off many others

Debt consolidation is a form of debt refinancing that entails taking out one loan to pay off many others. This commonly refers to a personal finance process of individuals addressing high consumer debt, but occasionally it can also refer to a country's fiscal approach to consolidate corporate debt or Government debt. The process can secure a lower overall interest rate to the entire debt load and provide the convenience of servicing only one loan or debt.

Alternative financial services in the United States refers to a particular type of financial service, namely subprime or near-prime lending by non-bank financial institutions. This branch of the financial services industry is more extensive in the United States than in some other countries, because the major banks in the U.S. are less willing to lend to people with marginal credit ratings than their counterparts in many other countries. Examples of these companies include Springleaf Financial, Duvera Financial, Inc., Lendmark Financial Services, Inc., HSBC Finance, CIT, CitiFinancial, Wells Fargo Financial, and Monterey Financial Services, Inc. The more generic name "consumer finance" is also used, although more properly this term applies to financing for any type of consumer.

Payday loan Small, short-term unsecured loan

A payday loan is a small, short-term unsecured loan with high interest rates.

Loan shark person who offers loans at extremely high interest rates

A loan shark is a person who offers loans at extremely high interest rates, has strict terms of collection upon failure, and generally operates outside of local authority. Loan sharking is usually illegal, but predatory lending with extremely high interest rates such as payday or title loans is sometimes considered loan sharking.

Predatory lending refers to unethical practices conducted by lending organizations during a loan origination process that are unfair, deceptive, or fraudulent. While there are no internationally agreed legal definitions for predatory lending, a 2006 audit report from the office of inspector general of the US Federal Deposit Insurance Corporation (FDIC) broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers", though "unfair" and "abusive" were not specifically defined. Though there are laws against some of the specific practices commonly identified as predatory, various federal agencies use the phrase as a catch-all term for many specific illegal activities in the loan industry. Predatory lending should not be confused with predatory mortgage servicing which is mortgage practices described by critics as unfair, deceptive, or fraudulent practices during the loan or mortgage servicing process, post loan origination.

A home equity line of credit, or HELOC, is a loan in which the lender agrees to lend a maximum amount within an agreed period, where the collateral is the borrower's equity in their house. Because a home often is a consumer's most valuable asset, many homeowners use home equity credit lines only for major items, such as education, home improvements, or medical bills, and choose not to use them for day-to-day expenses. HELOC abuse is often cited as one cause of the subprime mortgage crisis.

Unsecured debt

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. Unsecured debt are sometimes called as signature debt or personal loan. These differ from secured debt such as a mortgage, which is backed by a piece of real estate, or gold in case of Gold Loan or other securities like Fixed Deposits, Shares or insurance papers.

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as a lender's protection against a borrower's default and so can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.

Credit loan

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

Commercial mortgage mortgage loan secured by commercial property

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

The vast majority of all second lien loans are senior secured obligations of the borrower. Second lien loans differ from both unsecured debt and subordinated debt.

Mortgage loan loan secured using real estate

A mortgage loan or simply mortgage is a loan used either by purchasers of real property to raise funds to buy real estate, or alternatively by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

In finance, subprime lending is the provision of loans to people who may have difficulty maintaining the repayment schedule. Historically, subprime borrowers were defined as having FICO scores below 600, although this threshold has varied over time.

Payday loans in the United States Overview of payday loans

A payday loan is a small, short-term unsecured loan, "regardless of whether repayment of loans is linked to a borrower's payday." The loans are also sometimes referred to as "cash advances," though that term can also refer to cash provided against a prearranged line of credit such as a credit card. Payday advance loans rely on the consumer having previous payroll and employment records. Legislation regarding payday loans varies widely between different countries and, within the United States, between different states.

A guarantor loan is a type of unsecured loan that requires a guarantor to co-sign the credit agreement. A guarantor is a person who agrees to repay the borrower’s debt should the borrower default on agreed repayments. The guarantor is often a family member or trusted friend who has a better credit history than the person taking out the loan and the arrangement is, therefore, viewed as less risky by the lender. A guarantor loan can, consequently, enable someone to borrow either more money, or the same amount at a lower rate of interest, than they would otherwise be able to secure through a more traditional type of loan.

Credit agreements in South Africa are agreements or contracts in South Africa in terms of which payment or repayment by one party to another is deferred. This entry discusses the core elements of credit agreements as defined in the National Credit Act, and the consequences of concluding a credit agreement in South Africa.

A business loan is a loan specifically intended for business purposes. As with all loans, it involves the creation of a debt, which will be repaid with added interest. There are a number of different types of business loans, including bank loans, mezzanine financing, asset-based financing, invoice financing, microloans, business cash advances and cash flow loans.

References

  1. Signoriello, Vincent J. (1991), Commercial Loan Practices and Operations, ISBN   978-1-55520-134-0
  2. Subsidized Loan - Definition and Overview at About.com . Retrieved 2011-12-21.
  3. Concessional Loans, Glossary of Statistical Terms, oecd.org, Retrieved on 5/5/2013
  4. "Average new-car loan a record 65 months in fourth quarter". Reuters. August 6, 2017. Retrieved 2017-08-06.
  5. Guttentag, Jack (October 6, 2007). "The Math Behind Your Home Loan". The Washington Post. Retrieved May 11, 2010.
  6. "Predators try to steal home". money.cnn.com. [CNN]. 18 Apr 2000. Retrieved 7 Mar 2018.
  7. Horsley, Scott; Arnold, Chris (2 Jun 2016). "New Rules To Ban Payday Lending 'Debt Traps'". National Public Radio . Retrieved 7 Mar 2018.
  8. "Credit cardholders pay Rs 6,000 cr 'extra'". The Financial Express (India). Chennai, India]. 3 May 2007. Archived from the original on 2007.
  9. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Ed. (2007).
  10. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) (giving the three-prong standard for what is "income" for tax purposes: (1) accession to wealth, (2) clearly realized, (3) over which the taxpayer has complete dominion).
  11. 26 U.S.C. 61(a)(4)(2007).
  12. 26 U.S.C. 61(a)(12)(2007).
  13. 26 U.S.C. 108(2007).
  14. EUGENE A. LUDWIG AND PAUL A. VOLCKER, 16 November 2012 Banks Need Long-Term Rainy Day Funds