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In
finance, a loan is the lending of
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a
debt
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 ...
and is usually liable to pay
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...
on that debt until it is repaid as well as to repay the principal amount borrowed.
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
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
(s) for a period of time, between the
lender
A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property ...
and the
borrower
A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...
.
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
A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tr ...
, which can also place the borrower under additional restrictions known as
loan covenant
A loan covenant is a condition in a commercial loan or bond
Bond or bonds may refer to:
Common meanings
* Bond (finance), a type of debt security
* Bail bond, a commercial third-party guarantor of surety bonds in the United States
* Chemical bond ...
s. 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 institution
Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial inst ...
s 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
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) 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, an ...
is a form of debt in which the borrower
pledges some asset (i.e., a car, a house) as
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
.
A
mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any ...
is a very common type of loan, used by many individuals to purchase residential or commercial property. The lender, usually a financial institution, is given security a
lien
A lien ( or ) is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation. The owner of the property, who grants the lien, is referred to as the ''lienee'' and the per ...
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:
*
Credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
s
*
Personal loans
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 t ...
*
Bank
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
overdrafts
* Credit facilities or lines of credit
*
Corporate bonds (may be secured or unsecured)
*
Peer-to-peer lending
The
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
s 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
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
A prime rate or prime lending rate is an interest rate used by banks, usually the interest rate at which banks lend to customers with good credit. Some variable interest rates may be expressed as a percentage above or below prime rate.
Use in dif ...
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
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territori ...
, it refers to a loan on which no interest is accrued while a student remains enrolled in education.
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. Such loans may be made by foreign governments to developing countries or may be offered to employees of lending institutions as an
employee benefit
Employment is a relationship between two parties regulating the provision of paid labour services. Usually based on a contract, one party, the employer, which might be a corporation, a not-for-profit organization, a co-operative, or any oth ...
(sometimes called a ''perk'').
Target markets
Loans can also be categorized according to whether the debtor is an individual person (consumer) or a business.
Personal
Common personal loans include
mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any ...
s, car loans, home equity lines of credit,
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
s,
installment loan An installment loan is a type of agreement or contract involving a loan that is repaid over time with a set number of scheduled payments; normally at least two payments are made towards the loan. The term of loan may be as little as a few months and ...
s, and
payday loans
A payday loan (also called a payday advance, salary loan, payroll loan, small dollar loan, short term, or cash advance loan) is a short-term unsecured loan, often characterized by high interest rates.
The term "payday" in payday loan refers to ...
. 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. 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 mortgage
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 ...
s and
corporate bonds and government guaranteed loans Underwriting is not based upon credit score but rather
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
.
Loan payment
The most typical loan payment type is the fully
amortizing payment in which each monthly rate has the same value over time.
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 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 200 ...
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 them; subprime mortgage-lending and payday-lending are two examples, where the moneylender is not authorized or
regulated
Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. Fo ...
, the lender could be considered a
loan shark
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 the law.
Description
Because loan sharks operate mostly illegally, they cannot reasonably ...
.
Usury
Usury () is the practice of making unethical or immoral monetary loans that unfairly enrich the lender. The term may be used in a moral sense—condemning taking advantage of others' misfortunes—or in a legal sense, where an interest rate is c ...
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".
Abuses can also take place in the form of the customer defrauding the lender by borrowing without intending to repay the loan.
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).
[Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Ed. (2007).]
1. A loan is not gross income to the borrower.
Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth.
2. The lender may not deduct (from own gross income) the amount of the loan.
The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment).
Deductions are not typically available when an outlay serves to create a new or different asset.
3. The amount paid to satisfy the loan obligation is not deductible (from own gross income) by the borrower.
4. Repayment of the loan is not gross income to the lender.
In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender.
5. Interest paid to the lender is included in the lender's gross income.
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.
Interest income can be attributed to lenders even if the lender doesn't charge a minimum amount of interest.
6. Interest paid to the lender may be deductible by the borrower.
In general, interest paid in connection with the borrower's business activity is deductible, while interest paid on personal loans are not deductible.
The major exception here is interest paid on a home mortgage.
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.
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 income
Taxpayers in the United States may have tax consequences when debt is cancelled. This is commonly known as cancellation-of-debt (COD) income. According to the Internal Revenue Code, the discharge of indebtedness must be included in a taxpayer's gr ...
) of the
Internal Revenue Code.
[EUGENE A. LUDWIG AND PAUL A. VOLCKER, 16 November 201]
Banks Need Long-Term Rainy Day Funds
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See also
US specific:
References
{{Authority control
Loans
Banking terms
Notary