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
In Nigeria, there are two types of loans. 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.
- 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.