What Is a Loan? A loan is money, property, or other material goods given to another party in exchange for future repayment of the loan value or principal amount, along with interest or finance charges. A loan may be for a specific, one-time amount or can be available as an open ended line of credit up to a specified limit or ceiling amount. Loans are typically issued by corporations, financial institutions, and governments. The interest and fees from loans are a primary source of revenue for many banks. They can also take the form of bonds or certificate of deposit How a Loan Works The terms of a loan are agreed to by each party in the transaction before any money or property changes hands. If the lender requires collateral, this requirement will be outlined in the loan documents. Most loans also have provisions regarding the maximum amount of interest, as well as other covenants such as the length of time before repayment is required. Key Takeaways

Types of Loans

A number of factors can differentiate loans and affect their costs and terms.

Secured vs. Unsecured Loan

Mortgages and car loans are secured loans, as they are both backed or secured by collateral.

Loans such as credit cards are unsecured or not backed by collateral. Unsecured loans typically have higher interest rates than secured loans, as they are riskier for the lender. With a secured loan, the lender can repossess the collateral in the case of default. However, interest rates vary wildly on unsecured loans depending on multiple factors, including the borrower's credit history.

Revolving vs. Term

Revolving refers to a loan that can be spent, repaid and spent again, while term loans refer to a loan paid off in equal monthly installments (EMI) over a set period. A credit card is an unsecured, revolving loan, while a home loan is a secured revolving loan. In contrast, a car loan is a secured loan.

Special Considerations for Loans

Interest rates have a significant effect on loans and the ultimate cost to the borrower. Loans with high interest rates have higher monthly payments—or take longer to pay off—than loans with low interest rates.

  Simple vs. Compound Interest

The interest rate on loans can be set at a simple interest or a compound interest. Simple interest is interest on the principal loan, which banks almost never charge borrowers.

Compound interest is interest on interest and means more money in interest has to be paid by the borrower. The interest is not only applied to the principal but also the accumulated interest of previous periods. The bank assumes that at the end of the first year, the borrower owes it the principal plus interest for that year. At the end of the second year, the borrower owes it the principal and the interest for the first year plus the interest on interest for the first year.

The interest owed, when compounding is taken into consideration, is higher than that of the simple interest method because interest has been charged monthly on the principal loan amount, including accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, the disparity between the two types of interest calculations grows.

Peer-To-Peer Lending (P2P)

What Is Peer-To-Peer Lending?

Peer-to-peer (P2P) lending enables individuals to obtain loans directly from other individuals, cutting out the financial institution as the middleman. Websites that facilitate peer-to-peer lending have greatly increased its adoption as an alternative method of financing.

P2P lending is also known as social lending or crowdlending, many peer-to-peer loans are unsecured personal loans, though some of the largest amounts are lent to businesses. Secured loans are sometimes offered by using luxury assets such as jewellery, watches, vintage cars, fine art, buildings, aircraft, and other business assets as collateral. They are made to an individual, company or charity. Other forms of peer-to-peer lending include student loans, commercial and real estate loans, payday loans, as well as secured business loans, leasing, and factoring.

The lending intermediaries are for-profit businesses; they generate revenue by collecting a one-time fee on funded loans from borrowers and by assessing a loan servicing fee to investors or borrowers (either a fixed amount annually or a percentage of the loan amount). Compared to stock markets, peer-to-peer lending tends to have both less volatility and less liquidity.

The Reserve Bank of India (RBI) regulates Peer to Peer Lending platforms to protect the interest of lenders and borrowers. P2P Lending is taking-off steadily in India. If you haven’t investing in this new asset class, this is the best time for you to start investment, especially when the RBI started regulating P2P lending activity in India.

Key Takeaways

1.P2P lending websites connect borrowers directly to investors. The site sets the rates and terms and enables the transaction.
2.P2P lenders are individual investors who want to get a better return on their cash savings than a bank savings account or CD offers.
3.P2P borrowers seek an alternative to traditional banks or a better rate than banks offer.
Any consumer or investor considering using a peer-to-peer lending site should check the fees on transactions.

Understanding Peer-To-Peer Lending

P2P lending websites connect borrowers directly to investors. The site sets the rates and the terms and enables the transaction. Most sites have a wide range of interest rates based on the creditworthiness of the applicant.

First, an investor opens an account with the site and deposits a sum of money to be dispersed in loans. The loan applicant posts a financial profile that is assigned a risk category that determines the interest rate the applicant will pay. The loan applicant can review offers and accept one.

(Some applicants break up their requests into chunks and accept multiple offers.) The money transfer and the monthly payments are handled through the platform.

The process can be entirely automated or lenders and borrowers can choose to haggle. Some sites specialize in particular types of borrowers.

How P2P Lending Evolved

Early on, the P2P lending system was seen as offering credit access to people who would be spurned by conventional institutions, or a way to consolidate student loan debt at a more favourable interest rate. In recent years, however, peer-to-peer lending sites have expanded their reach. Most now target consumers who want to pay off credit card debt at a lower interest rate.

Home improvement loans and auto financing are now available at peer-to-peer lending sites.

The rates for applicants with good credit are often lower than comparable bank rates. Rates for applicants with sketchy credit records may go much higher.

The average credit card interest rate was 17.67% as of March 27, 2019.

For lenders, peer-to-peer lending is a way to generate interest income on their cash at a rate that exceeds those offered by conventional savings accounts or certificates of deposit (CD).

Special Considerations

Peer-to-peer lending is controversial. An analysis by the Cleveland Federal Reserve in 2017 warned that consumer lending through peer-to-peer sites was beginning to resemble the sub-prime mortgage lending system that caused the 2008 financial crisis. That is, as the sites expanded their reach they began loosening their standards, leading to higher default rates.

It also had a warning for consumers: People who consolidate consumer debt through peer-to-peer lending sites tend to wind up with even more overall debt when they begin to use credit cards freed up by their loans.

It noted that nearly 16 million American consumers had personal loans through peer-to-peer lending sites by the end of 2016.

A Warning for Investors

People who are considering joining a peer-to-peer lending site as investors need to worry about default rates, as do conventional banks. An S&P/Experian composite index of default rates across all types of lending to U.S. borrowers has been fluctuating between about 0.8% and 1% since April 2015. The default rate on U.S. credit card debt fluctuates much more, hitting a high of 9.1% in April 2015 but dropping to 3.56% in mid-2018.

Any consumer or investor considering using a peer-to-peer lending site should check the fees on transactions. Every site makes money differently, but fees and commissions may be charged the lender, the borrower, or both. Like banks, the sites may charge loan origination fees, late fees, and bounced-payment fees.