Loan

A loan is an agreement in which a lender hands a sum of money to a borrower, who promises to pay it back over an agreed period, usually with interest. The amount borrowed is the principal, the time allowed is the term, and the price is the interest rate plus any fees.

Loans are the most common form of credit and the largest asset on most bank balance sheets. They differ from a revolving facility such as an overdraft or a credit card, where the customer can borrow, repay and borrow again up to a limit; a standard loan is paid out once and then reduced to zero. For the borrower a loan is debt; for the lender it is a claim that earns income until it is repaid.

A loan is like renting money. When you rent a flat, you pay rent each month for the right to use something that belongs to someone else, and at the end you hand it back. With a loan you get the use of the money now, pay rent on it in the form of interest, and give the money itself back over time.

Most loans are paid back in equal monthly instalments. Early on, much of each payment is rent for the money; later, more of it goes towards handing the money back. Some loans also ask you to put something up as a promise, such as your car or house, which the lender can take if you stop paying.

• Principal. The sum actually borrowed, which falls as repayments are made.
• Interest rate. The yearly price of borrowing, either fixed for the term or variable, moving with a benchmark such as SOFR in the US or KIBOR in Pakistan. The full cost including fees is shown as an Annual Percentage Rate (APR).
• Term. How long the borrower has to repay, from a few weeks for a payday loan to 25 or 30 years for a mortgage.
• Repayment schedule. How and when payments are made, often by direct debit or a standing order.
• Security. Whether the loan is backed by an asset, and the covenants and conditions the borrower must keep.

A secured loan is backed by collateral. If the borrower fails to pay, the lender can take and sell the asset. Home loans, car finance and collateralized loans to businesses work this way, and some, such as car title loans, are notorious for high costs. In crypto markets, over-collateralized loans require the borrower to lock up more value than is borrowed.

An unsecured loan relies only on the borrower's promise and credit record. Personal loans, student loans and most small business credit lines fall here. Because the lender has nothing to sell if things go wrong, uncollateralized loans usually carry higher rates and lower limits, and approval depends heavily on the borrower's credit score.

Most consumer loans are amortising: each payment covers that period's interest and repays part of the principal, so the balance reaches zero at the end. The fixed payment is found with the standard annuity formula:

• $M$ is the payment made each period.
• $P$ is the principal borrowed.
• $r$ is the interest rate per period, as a decimal (the annual rate divided by 12 for monthly payments).
• $n$ is the total number of payments.

Worked example: a borrower takes 10,000 at 12% a year, repaid monthly over one year. Then $P = 10{,}000$, $r = 0.12 \div 12 = 0.01$ and $n = 12$. Since $1.01^{12} \approx 1.1268$, the payment is $10{,}000 \times \frac{0.01 \times 1.1268}{0.1268} \approx 888.49$ a month. Over the year the borrower pays about 10,662, of which roughly 662 is interest. In the first month, interest is 100 (1% of 10,000) and 788.49 reduces the principal; by the last month almost the whole payment is principal.

Other structures exist. An interest-only loan pays just the interest and returns the principal in one lump sum at the end, much like a bond. A bullet or balloon loan repays most of the principal at maturity. Interest is normally charged on the falling balance, which is why compound interest works against borrowers who miss payments.

For banks, loans are the main source of income and of risk. Supervisors watch the share of non-performing loans (NPLs) and the advances-to-deposit ratio (ADR), which compares lending with bank deposits. Loans can also be packaged and sold to investors through securitization, and firms or governments may borrow abroad through foreign currency loans.

Not every system uses interest. Islamic banks avoid interest-bearing loans and instead finance purchases through sale or lease contracts such as murabaha and ijarah, while consumer laws in most countries guard against predatory lending.

• Consumer Financial Protection Bureau
• Financial Conduct Authority: Consumers