A loan is a sum of money advanced by a creditor to a borrower. The borrower agrees to repay the money over an agreed period, usually with interest. The creditor may require the borrower to provide some form of security such as a guarantor and/or evidence of assets.
Examples of loans
In the UK, loans generally come in two main forms: personal loans and business loans. Both loans can be further subdivided into smaller categories. For example, the category of personal loans includes student loans, car loans and mortgages.
The category of business loans includes working-capital loans, asset financing and invoice financing. Bonds are also, effectively, business loans. The mechanics of bonds, however, work differently from the mechanics of regular loans.
Why are loans used?
In the consumer world, personal loans are generally used to finance purchases a consumer would not otherwise be able to afford. For example, many people can only buy a house if they can get a mortgage. Personal loans can also be used for debt consolidation.
In the business world, loans tend to be used to finance growth. This allows a company to grow more quickly than it could have done just using its own income. Company owners may prefer borrowing to getting investment as it allows them to retain full control over their company.
Some businesses may also use loans simply to establish a credit history. As they repay the loan, they improve their credit rating. Over time, their credit score will increase. This will make it easier for them to get financing at a decent interest rate if they ever actually need it.
Loans versus revolving credit
A loan is a specific sum of money lent for an agreed period of time. Most loans have a regular repayment schedule. In the UK, monthly repayments are standard.
Revolving credit is an agreement that a creditor will make a certain amount of credit available to a borrower. The borrower may or may not access this credit. If they do access the credit, they can borrow as little or as much as they wish up to their credit limit.
The borrower’s monthly payments depend on the amount borrowed in that particular month (and the interest rate). They will go on indefinitely unless the borrower or the creditor decides to cancel the arrangement.
Two common examples of revolving lines of credit are overdrafts and credit cards. Both are available to consumers and businesses. Businesses may also be able to access business lines of credit.
Loans versus instalment plans
Instalment plans are loans that meet specific criteria defined by the FCA. In particular, they can only be for a maximum of 12 instalments over a maximum of 12 months. They can be shortened but not extended (or renewed) and they cannot include any interest or charges.
As long as these criteria are met, instalment plans can be offered without explicit FCA authorisation. The main implication of this is that businesses can offer their customers the option to pay for goods/services by instalment. This includes business customers (such as B2B transactions).
Loans versus bonds
Bonds are essentially a form of peer-to-peer lending. They work very similarly to crowdfunding. Businesses define how much money they need and for how long. They set out the interest rate they are willing to pay. They may also set out minimum and maximum limits for creditors.
As with loan rates, the interest rates for bonds will reflect the going market rates for that type of debt. The business’ perceived reliability will also be taken into consideration. For example, potential creditors will probably want to know the company’s credit score and income.