Loan terminologies are not so obvious and can lead to misunderstanding. We have chosen commonly used terms that you will come across when applying for loans or even as you watch business news.
Difference between secured and unsecured loan
The first of the loan terminologies is a secured loan. The first thing to understand about debt is the difference between a secured loan and an unsecured one. With a secured loan, you offer something of value as collateral for your borrowing. Your lender can then sell that item if you don’t pay back what you owe, or at least recover part of the loan owed. The most common example here would be a car loan. If you borrow money to buy a loan, the car becomes the security even as you use it. You will sign documents to the bank that will give them the legal right to repossess the car in the event that you fail to pay. Security is not the only consideration when banks are considering loans.
Another important loan terminology is Unsecured loans. On the other hand, for an unsecured loan, you don’t have anything to offer as collateral. The lender has rated you and found that you are likely to repay the loan without any problems. If you can’t make monthly payments on time, there’s nothing that the lender will be able to do other than sue you. This is a very risky type of borrowing. Lenders tend not to approve applications for this kind of loan unless they really trust the borrower. But one would ask why banks offer unsecured loans? The answer is that there are many people out there with a good credit score. Additionally, they charge interest rates that are significantly higher in order to compensate for the added risk.
#3. Credit score
A credit score is a numerical expression of your credit history and measures your likelihood of defaulting in the future. If your credit score ranges between 670 and 739 then you are considered good. Any score above this is considered, even better. Unsecured loans also tend to have a much more negative effect on your credit score than secured ones once you default. This is undesirable exposure to the bank. They may even report this information directly onto your credit history, depending on how serious they judge the situation to be. Other financial institutions who do background checks before approving applications for new lines of credit and sometimes even landlords during the rental application process will not be willing to approve your request.
Revolving vs Non-revolving credit
#4. Revolving credit
That brings us to the next important loan terminologies. Revolving vs non-revolving credit. With a revolving line of credit, when you make a loan repayment, the amount becomes available for you to borrow immediately. These types of facilities are transactional and become available once the previous one is repaid. Most revolving loans are reviewed after every year. Renewal is based on the borrowers’ repayment history. This is one of the loan terminologies that you will keep hearing about.
#5. Non-revolving loans
As the name suggests, revolving loans are specific to a project. For example, if you take a loan to build a factory, it is unlikely that you will be borrowing for the same project at the end of the year. Once this loan is repaid, your requirements might be different. The interest rate charged is likely to be higher because of the repayment period.
#6. Associated costs
Costs associated with debt vary but mainly fall under borrowing fees, interest rates, and non-payment penalties. Borrowing fees can be a percentage of a loan or a flat amount. Interest rates are basically the carrying cost of a loan plus some profit margin. Non-payment penalties are fees you pay for not paying loans on time. This is one of the loan terminologies that most people ignore, yet these costs are important and add up.
#7. Net worth
You probably have someone speak about net worth. Net worth is the sum total value of all your assets less the total amount that you owe. In accounting, it is also known as net of total assets to total liabilities. Positive net worth is when the value of total assets exceeds the total loans. Negative net worth is undesirable and a sign of a risky borrower. You are therefore unlikely to get approved if you have a negative net worth.
#8. Funded vs Non-funded facilities
Funded facilities refer to loans where money is actually put in your account or where the bank makes payment to a third party on your behalf. For example, when the bank gives you a motor loan, this is a funded facility. Funded loan terminologies are used in commercial loans and more sophisticated borrowers. Non-funded in loan terminologies refers to facilities where no funds are involved, such as bank guarantees and letters of credit. These are trade finance facilities required by commercial customers.
#9. Balloon Payment
Balloon payment loan terminology is also another one that most people don’t ask about. Banks will normally agree with you for a monthly repayment loan until it is fully paid. But you can negotiate for provisions of a balloon payment clause in the agreement. This one allows you to make one large payment to clear the loan. You avoid prepayment penalties when with this clause. This is one of the loan terminologies that you should try to have included to save you that early repayment penalty.
#10. Bridging loan
Under a bridging loan, the borrower is disposing of a property but does not know when the transaction will be completed. The bank approves the loan on the understanding that that repayment will be from money received from the sale of the property.
#11. What is an Escrow Account?
Look at an escrow account as a security account. An escrow account is opened by the buyer, seller, and bank. The idea is removing power from any one of them having the ability to transact alone. The buyer and seller have mutual mistrust and bring the bank into an equation. For example, the buyer is prepared to deposit $1 million for the purchase of a property. The seller will only transfer the property when there is a low risk of no payment. That is when the bank opens the escrow account.
Read more about Commercial Loans
#12. Loan refinance
Refinancing a loan is easy. When you have reached a certain loan repayment of a property loan, for example, 50%. You can approach the bank for a new loan for the current value of the property. The loan will be used to clear the previous loan, leaving the balance in your account.
In conclusion, if you’re looking to borrow money, it’s best that you do so responsibly and with sound judgment. That doesn’t mean avoiding debt entirely since there are times when borrowing can help you acquire assets —but if something goes wrong either because of an unforeseen event or irresponsible spending habits (like taking out a loan but not doing anything useful with what was received) this can have serious consequences on your financial well-being now as well as in the long run.
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