In basic economics, a loan is a borrowing of money by one or several people, institutions, or other entities normally for the specific purpose of acquiring material possessions such as tools, raw materials, capital goods and so on. The borrower is then obligated to pay interest on this debt and eventually to repay the total principal sum borrowed as well. Loans are often secured by property such as real estate, which can be repossessed if the debtor fails to meet his obligations. In contrast, unsecured loans are not backed by any material possession and, therefore, the risk of non-payment lies with the person or institution who offers the loan rather than with the borrower.
There are two types of loan: long-term and short-term. A long-term loan, also called an asset-based loan, is a loan that is used for the purchase of fixed assets such as plant and equipment. These assets cannot be replaced as the loan’s principal value wanes. Thus, the lender must be able to guarantee payment of the principal and interest over the course of a set period of time. If the value of the asset declines, the lender must absorb the loss of the amount owed to him. The most typical example of a long-term loan is a home equity loan.
Conversely, a short-term loan refers to a loan that is given with a specified interest rate and repayment term. It would be impossible for a person to extend this loan indefinitely because there are no new assets to purchase and no income to provide for repayment. Since a borrower has to repay the principle amount within a defined time, short-term loans are often associated with high interest rates. However, even these interest rates are still considerably lower than the interest rates applicable to long-term loans. As a general rule, borrowers who take up a short-term loan would owe more principal in relation to the amount they take out than those who take up long-term loans.
Another example of a revolving loan is a credit card. Credit card companies offer their clients a certain amount of credit per month. Usually, at the end of that month, they require the client to pay all outstanding balances, including the outstanding balance on the credit card. In this case, the term of the revolving loan would be one year.
Some people use unsecured loans for high interest rates on goods or services that do not change hands often. Examples include cars, which can appreciate in value very quickly. Other goods or services are goods that are in constant motion, such as transportation. With unsecured loans, interest rates are usually very high. Because many credit cards carry similar interest rates to unsecured loans, it would be wise to compare credit cards and other types of loans to see which ones offer the lowest interest rates.
As a borrower, it is important to understand how the loan process works. Paying off a loan early (or failing to repay a loan in full in the first year plus interest) results in compound interest. Compound interest means that interest is paid on the amount of the original loan plus any additional interest due on the money owed plus any applicable penalties. With compound interest, the borrower pays on the loan principal every single month and does not pay off the original principal. It is important to remember that with each monthly payment, the borrower pays the same amount plus compound interest. The more money borrowed, the greater the amount of compound interest.