What is A loan?

A loan is a financial transaction in which one party (the lender) agrees to give another party (the borrower) a certain amount of money with the expectation of total repayment. The specific terms of a loan are often spelled out in the form of a promissory note or other contract. The lender can ask for interest payments in addition to the original amount of the loan (principal). The borrower must agree to the repayment terms, including the amount owed, interest rate and due dates. Some lenders can also assign financial penalties for missed or late payments.

Because a loan can contain many hidden costs such as interest payments and finance charges, many people tend to avoid applying for one until it becomes absolutely necessary. Purchasing a new vehicle or home almost always necessitates some form of financial loan, whether it be a bank mortgage or a private loan with the seller. Financing a higher education may also require a federally-backed student loan. Interest rates on these types of large loans can be fixed at the time of the application or may vary according to the federal prime interest rate.

There is a very important legal difference between a gift and a loan. A very generous relative or friend may give you $5000 for car repairs, for example. If there is no expectation of repayment, the money can be considered a gift. The giver could not sue for repayment later in a civil lawsuit. But if the lender designates the money as a loan and the borrower pays back even one dollar, the money can be considered a legal loan and the lender can demand repayment any time. Small claims courts spend much of their time determining whether or not a transaction involving money was a gift or loan. This is why paperwork is essential when making private loans to friends or relatives.

Most loan applications are handled by banks or other professional lending institutions. They may use any number of criteria to determine if a potential borrower is eligible for a loan. Past credit history is almost always considered, along with current income and assets. The purpose of the loan may also be a factor--a proven investment opportunity may have more appeal than an unproven idea for a new restaurant. One important consideration is the income to debt ratio of the borrower. Can the borrower afford to pay the loan back with interest? Professional lenders essentially 'sell' money, so borrowers must realize how much a loan actually 'costs' in terms of real dollars and cents.