Definition in Detail
A bank loan (or bank advance) refers to a specified sum of money that a bank lends to a customer, typically for a designated period and at a specified rate of interest. The term ‘bank loan’ encompasses various types of loans issued to individuals, businesses, or other entities. These loans can be secured (backed by collateral) or unsecured, depending on the borrower’s creditworthiness and the nature of the loan.
Key Components:
- Principal: The amount of money lent.
- Interest Rate: The cost of borrowing, expressed as a percentage of the principal.
- Term: The duration over which the loan must be repaid.
- Security (Collateral): Assets pledged by the borrower to secure the loan.
- Repayment Schedule: Specifies how and when the loan must be repaid.
Examples
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Personal Loan: John needs $10,000 to consolidate his debt. He approaches his bank, which agrees to provide the sum at a 7% interest rate over a three-year term. This would be an unsecured personal loan as it isn’t backed by collateral.
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Commercial Loan: A small business seeks $200,000 to expand its operations. The bank reviews the company’s financial statements and regards it as a good credit risk. Thus, it offers the loan without requiring any security, albeit at a higher interest rate.
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Secured Loan: Ana wants to buy a house priced at $300,000. She pays $60,000 as a down payment and takes a bank loan for the remaining $240,000. To secure the loan, her house is used as collateral.
Frequently Asked Questions
What are the types of bank loans?
- Secured Loans: Backed by collateral such as property or assets.
- Unsecured Loans: Not backed by collateral, typically have higher interest rates due to increased risk.
- Fixed-Rate Loans: Interest rate remains constant throughout the loan term.
- Variable-Rate Loans: Interest rate can fluctuate based on market conditions.
How do banks assess credit risk?
Banks assess credit risk using several factors, including the borrower’s credit history, income, existing debt, and overall financial health. Businesses may need to provide comprehensive financial statements.
What is the difference between a secured and an unsecured loan?
A secured loan is backed by collateral, reducing the lender’s risk and often resulting in lower interest rates. An unsecured loan doesn’t have collateral, posing higher risk to lenders and typically carrying higher interest rates.
What happens if I default on a secured loan?
If you default on a secured loan, the lender has the right to seize the asset used as collateral to recoup the outstanding loan amount.
How can I reduce my interest rate on a bank loan?
Improving your credit score, providing collateral, choosing a shorter loan term, and maintaining a stable income can help you secure a lower interest rate.
Related Terms with Definitions
Overdraft
An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. Essentially, it allows a customer to borrow a set amount of money and can be a form of bank loan.
Credit Risk
Credit risk refers to the probability of a borrower defaulting on their loan obligations. It is assessed by examining the borrower’s past financial behavior, credit history, and current financial status.
Interest Rate
The proportion of a loan charged as interest to the borrower, typically expressed as an annual percentage of the loan’s outstanding principal.
Collateral
An asset pledged by a borrower to secure a loan or other credit and subject to seizure in the event of default.
Principal
The original sum of money borrowed in a loan, or put into an investment, on which interest is calculated.
Online References
- Investopedia
- Federal Reserve Bank: Consumer Protection
- NerdWallet: Personal Loans Guide
- U.S. Small Business Administration: Loans & Grants
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen.
- “Bank Management & Financial Services” by Peter S. Rose and Sylvia C. Hudgins.
- “Financial Markets and Institutions” by Frederic S. Mishkin and Stanley G. Eakins.
- “Commercial Banking: The Management of Risk” by Benton E. Gup and James W. Kolari.
- “Bank Management” by Timothy W. Koch and S. Scott MacDonald.
Accounting Basics: “Bank Loan (Bank Advance)” Fundamentals Quiz
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