What is actually a Loan?

A loan is an agreement in which one person lends money to another. The person receiving the loan is called the borrower and the person lending is called the lender. The lender expects to be repaid at some point in time, which makes a loan different from a grant or gift.

The principle of a loan is very simple. The practice is much more complex because over time a whole range of different lending practices have developed, and lots of new terms have been introduced, which can be confusing.

Here is some basic information about loans.

1. What can be loaned? We tend to think of loans as being money, but they can be anything. Whenever you let someone borrow something for a short while, even a pencil, that is a loan. When a ‘thing’ is loaned, rather than money, the ‘thing’ is usually called an asset.

2. Private loans. Lending that pencil was a private loan. It may be that you want to lend somebody some money or use of an asset (an electric drill, a car or a house) for a longer period of time. This is a private loan, based on a verbal agreement.

3. Term of a loan. A loan is expected to be repaid, and the period over which it is repaid is called the term. It might be that the loan is repaid in full at the end of the term, or in instalments during the term. It depends on the agreement that was made and nature of the loan. It’s hard to repay a borrowed boat in instalments! A loan might be open-ended, with no defined term.

4. Defaulting on a loan. This happens when the borrower cannot repay the loan for some reason. The lender and borrower need to come to some arrangement about the outcome. The lender might agree to write-off the loan, accepting that they will never get the money or asset back. Or they might want something else from the borrower.

5. Interest on a loan. Often when money is borrowed the lender wants repayment not only of the capital sum that was lent, but also some additional money on top. This represents money they might have made had they used the original capital in another way. Interest can also be charged on the loan of an asset.

6. Secured loan. If the lender wants to protect the value of their loan they may insist on having security, which is a guarantee that if the borrower cannot repay they will give the lender another asset. For example, your friend might lend you $1000 and you agree that if you can’t repay it they can have your car instead. The car may or may not be worth $1000 – the value of the security does not have to match the value of the loan.

7. Unsecured loan. This is where the lender has no rights to another piece of property if the borrower defaults on the loan.

Loans can get much more complex than described above, but these represent the underlying principles. A mortgage is simply a form of loan, usually secured on a building and repaid over a long period of time. Credit cards provide very short term loans for small purchases. Loans might come in very different forms and use very different language, but they are all based on the process of one person letting someone borrow money or property.