In financial terms, a loan is money you (the borrower) receive from a bank or financial institution with an agreement to pay back the principal amount, plus interest within a specified time.
Loans are useful for the economy because by lending to new businesses; there is an opportunity for more healthy competition, which in turn increases overall cash flow in the marketplace.
Sometimes, the borrower will pledge some piece of property to the lender to secure the repayment of the loan. This property is the collateral. The interest rates paid on loans are also a primary source of income for the bank or financial institution.
Types Of Loans
There are two types of loans in Nigeria. Secured and Unsecured loans. All other types of loans typically fall under these two categories. Several factors differentiate the different types of loans. These factors also determine the terms and condition of the loans.
A secured loan is a loan that has the backing of a collateral, i.e. it is ‘secured’. A typical example is banks requiring loan applicants to present housing documents or proof of ownership of an asset until they repay the loan. The idea is that the lender can sell the asset to repay the loan should the borrower default on payment. Other assets used for collateral are stocks and bonds. Examples of secured loans are Mortgage loans and Term loans.
Mortgage Loans: A mortgage is a type of secured loan in which property or real estate is used as collateral. I.e. The property is ‘mortgaged’ until the borrower pays back the loan. A mortgage loan is also a home loan. You can use it for the purchase of a home.
Term Loan: This is a loan that banks and other financial institutions grant for an amount and repayment terms. The loan typically has a fixed interest rate and which you are to pay over a period. Most loans from financial institutions, especially banks, are term loans.
An unsecured loan, on the other hand, means that nothing is backing up the loan. That is, the borrower doesn’t need to put up any property or asset as collateral. For this category, financial institutions are comprehensive when assessing applicants. They meticulously look through financial records to estimate if the borrower can pay back the loan. Unsecured loans have more risks for the lenders, making the interest rates typically higher than secured loans.
Loans that fall in this category include:
- Personal Loan: This loan is granted to an individual for their personal use. Financial institutions give these loans out depending on the applicant’s credit history and capacity to payback.
- Credit Card Loan: This loan is money a person borrows with their credit card. The card permits them to make purchases when they don’t have cash. The lender provides the cash to make the purchases. However, the borrower is to pay back the loan at an agreed-upon time.
Other Categories of Loans that you should know about
Asides the two major types of loans, we can also classify loans according to the following categories:
According to the mode of repayment
Single payment loans:
Just as the name implies, this loan allows you to borrow a certain sum of money, and repay at once. However, it also requires you to pay the amount in full at a go, and within a fixed time.
Monthly payment loans:
Monthly payment loans takes the opposite turn compared to single payment loans and allows you repay gradually. Furthermore, it is scheduled in such a way that you repay a fixed amount every month depending on the loan principal and interest. Also, the date in which repayment starts are fixed during the loan process.
Salary advance loans:
This loan tends to short frame financial needs that arise before your paycheck. Also, it works by businesses subscribing to personal loan companies, therefore, giving their staff access to loan as a result. The loan is repaid by deduction from the staff’s next salary. Generally, salary advance loans comes with high interest rates and fees.
According to rates
Fixed rate loans:
Fixed rate means that the loan keeps the same interest rate throughout the span of the loan. Asides this, it could be any of the type loans explained in this article.
Variable rate loans:
This is the opposite of fixed rate loans because it comes with varying interest rates. Also, the interest rates are estimated based on certain changes to the underlying interest rate index. However, the rate has upper and lower limits, which it cannot move beyond within a time frame.
Installment loans are repaid with a set of scheduled payment. Usually, these loans could span really long (up to 30 years) or as little as a few months. A good example of installment loan is a mortgage. In essence, you borrow and pay up gradually.
These loans have a flexible nature and can be changed from one type to another. This means that they could start as a fixed-rate loan, but later switched to variable loan depending on the situation.
- Interest Rate and Repayment: It is essential to consider interest rates and repayment periods when choosing loan policies. Typically, the higher the interest rate on loan, the longer it will take to pay off the loan. Interest rates can be on either a simple or compound interest basis. Simple interest means a percentage of the principal amount.
- Compound interest: Compound interest, on the other hand, is the interest paid on interest. The borrower not only pays interest on the principal amount, but he also pays interest earned on both the principal amount and on the accumulated interest. Because interest is also earned on interest, earnings compound over time, like a snowball effect. It is favourable if you are the lender but works against the borrower as the more time it takes to pay back the loan, the more money you have to pay back. Time is money in this case.
Loans can be tricky. While they are an efficient one-time solution, it is easy to get sidetracked and lost in a cycle of repayment and debt. Many people lost homes as a result of their inability to pay back a loan. So before you apply for that loan, ensure that you can pay back at the specified time. It is also generally advisable to apply for loans on a strictly ‘need to’ basis, and not see them as a regular financial solution.