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How Do Loans Work?


A word you often hear in advertisements, or in other places in your everyday life, is loan. As the name implies, this is money that a lender, such as a bank, allows you to borrow.

When the bank chooses to loan you money, they wish to make a profit themselves. Therefore, the bank will charge you a fee for borrowing their money. This price is called interest.

Rule

This is what happens when you borrow money from the bank

1.
You go to the bank and request a loan, say for a house or a car. The bank needs to know how much you can borrow. You have to show that you have enough income to pay it back. This is called ability to repay. You have to present the bank with documentation, such as your paycheck stub, and proof of expenses and bank account balances, to demonstrate your ability to repay the loan.
2.
The bank wants security for the loan in the house/car you buy. If you don’t pay, they’ll take possession of the house/car you’ve bought, and sell it. In the case of a house, this is called foreclosure. In the case of a car, this is called repossession.
3.
You pay a sum of money each month. This sum is called your monthly payment. It is based on the total loan amount, which includes all fees. That amount is then divided up, usually into a number of months during which you will periodically make payments to repay the loan.
4.
The monthly payment is divided into two parts: Principal and interest. The principal is the part that covers paying off the loan. The interest is the price you pay the bank for lending you money, making it a pure expense for you.

Rule

The bank has two different kinds of interest rates:

Nominal interest rate:

The interest the bank demands, which is what the bank says it costs.

Real interest rate:

Nominal interest rate + all additional fees. This interest rate tells you how much your loan actually costs!

There are two main types of loans, serial loans and annuity loans. Most personal borrowers take out annuity loans. For both types of loans the monthly rate can calculated like this:

Formula

Monthly rate = interest + principal payment

Monthly rate = interest + principal payment

The way the interest and principal payment parts are calculated, and therefore what the monthly payment will be, is different between the two types of loans. In the next section, we will look at serial loans, and then after that, at the much more common annuity loans.

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What Is an Amortizing Loan?