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In finance, a loan is a debt provided by one entity (organization or
individual) to another entity at an interest rate, and evidenced by a note which
specifies, among other things, the principal amount, interest rate, and date of
repayment. A loan entails the reallocation of the subject asset(s) for a period
of time, between the lender and the borrower.
In a loan, the borrower
initially receives or borrows an amount of money, called the principal, from the
lender, and is obligated to pay back or repay an equal amount of money to the
lender at a later time. Typically, the money is paid back in regular
installments, or partial repayments; in an annuity, each installment is the same
amount.
The loan is generally provided at a cost, referred to as interest on
the debt, which 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,
which can also place the borrower under additional restrictions known as loan
covenants. 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
principal tasks for financial institutions. For other institutions, issuing of
debt contracts such as bonds is a typical source of funding.
A mortgage loan
is a very common type of debt instrument, used by many individuals to purchase
housing. In this arrangement, the money is used to purchase the property. The
financial institution, however, is given security ¡ª a lien on the title to the
house ¡ª until the mortgage is paid off in full. 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.
In some instances, a loan taken out to purchase a
new or used car may be secured by the car, in much the same way as a mortgage is
secured by housing. The duration of the loan period is considerably shorter ¡ª
often corresponding to the useful life of the car. There are two types of auto
loans, direct and indirect. A direct auto loan is where a bank gives the loan
directly to a consumer. An indirect auto loan is where a car dealership acts as
an intermediary between the bank or financial institution and the consumer.
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. 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.
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