4.1 Loans
Loans can have many conditions associated with them, which can vary from loan to loan. For example, some maybe simple such as a one month loan from a friend, some are more complex, such as a long-term loan from a financial institution to build a factory. Because loans can be so diverse, categories have been developed to help communicate some of the conditions of the loan. We will first introduce the most common conditions of loans and then explain how they are categorized based on these conditions.
4.1.1 Conditions of the loan
There are several details (i.e. conditions) that may vary or be negotiated between the borrower and the lender. These are generally agreed to and defined in a contract before money changes hands. The most common conditions include the:
- Principal: The amount of money lent/borrowed.
- Amortization period: The total length of time over which the borrower is expected to repay the loan.
- Interest rate: The cost of borrowing money expressed as a percent over a time period. (Refer to Chapter 3 Section 3.2 for more detail). When the interest rate is stated annually, it is called an annual percentage rate (APR) or nominal interest rate.
- Compounding frequency: This defines how often interest is calculated for a loan. It is usually expressed as the number of compounding periods per year.
- Payment frequency: This defines how often payments are made. E.g. weekly, monthly, annually.
- Term of the loan: The length of time the loan contract is in effect. This can be shorter than the amortization period. In such cases, a new loan contract is negotiated at the end of the term, unless the remaining principal is repaid.
- Collateral: This is an asset that belongs to the borrower that the lender can take if the borrower does not repay the loan. Thus, we say collateral is pledged as security on the loan.
All of these conditions are specified in the loan contract. For example, a company decides to borrow $300,000 to purchase new equipment. The loan contract states 4% APR for 5 years, compounded semi-annually with monthly payments. So, the principal is to be repaid over a 5-year period. To get the loan the company pledged a storage facility they own as security.
Here, the principal is $300,000. The amortization period is 5 years. The interest rate is 4%. The term of the loan is 5 years. The compounding frequency is semi-annual, or 2 times per year. The payment frequency is monthly, or 12 times per year. Storage facility is used as collateral.
Some of these conditions determine the size of the loan payments and how much interest will need to be paid over the term of the loan, therefore affecting the total amount of money the borrower must repay. This is illustrated in Figure 4.1 below
Figure 4.1. The Relationship Between Some of the Loan Conditions and Total Repayment Amount
As noted in the Figure 4.1, principal, amortization period, interest rate and compounding frequency positively correlate with the total amount of money the borr