by Stephan Smith on January 24, 2011

On this page I will be taking the time to explain what a “loan” is. If you didn’t know, loans play a very important role in modern societies. It is through loans where commercial banks make the majority of their profits. It is through loans where a majority of small businesses get the capital they need to jump start production of various goods and services. It is through loans where a majority of individuals get the financing needed to make major purchases for items like a car or a home.

Loans play a major part in our lives, but not everyone knows exactly what they are. Do you? If you would like to learn a little about what a loan is, the I would recommend that you read this page. Hopefully you will leave here with a good understanding as to what a loan is and have some understanding about the good and bad sides of loans.

What is a Loan

A loan is the lending of value by a lender to a borrower with agreed terms between the two parties, for the borrower to pay back the value lent by the lender, usually at interest. The value that is lent by a lender is usually a form of money, typically a kind of currency. The lender can be an individual, a business, an organization, a government or a financial institution like a commercial bank (I specifically gave a commercial bank as an example because commercial banks are the most prolific lenders).

A borrower can be an individual, a business, an organization, a government or a financial institution. In fact, any entity can lend value to any other entity that will accept it under the terms and conditions for repayment agreed upon by both parties. If a loan isn’t repaid for whatever reason, loan is consider to be in default. When a loan defaults, the lender would most likely lose the amount of money that hasn’t been repaid. The borrower that didn’t repay the money that was lent may face penalties and negative consequences of some sort, as well as find it difficult to find a lender to do business with in the future.

A businessman loaning money

Here is an image of a businessman loaning money to you. Remember, all loans must be repaid in some fashion. Can you handle the terms and conditions for repayment? It's a very important question.

Now it’s time to discuss the benefits to loans and why they are beneficial to an economy. Loans are beneficial to an economy because it allows individuals, organizations and other entities to finance purchases and investments they couldn’t other wise do without loans. Consider this example. If you owned an automotive manufacturing company and you needed additional capital goods like automated welding machines to help you produce cars at a quicker rate in order to meet the raising demand for your products, and you didn’t have the money necessary to make those major purchases, a loan would be a perfect solution.

By finding a lender willing to do business with you and loan you the necessary value (in this case, the value that is needed is currency), you could go and purchase those automated welding machines. After you have purchased those automated welding machines, you are now able to meet the increasing demand for your cars and as a result, you are able to make greater profits. With those greater profits you can now repay the lender the money that was lent to you plus the set interest (remember that not all loans have an interest, but most do).

What is the result of this example? The lender makes a profit because you, the borrower, paid back the lender in full including the interest (interest = the profit for the lender), you were able to get your automated welding machines and generate a greater profit for your business and you were able to fulfill an increasing demand in the economy. Everyone wins. If this example happens to many businesses, the economy as a whole will grow, employment opportunities will increase, economic prosperity will reign and everyone will be doing well. See, that is the beautiful side of loans. Loans can lead to economic prosperity if the conditions are right. The institution who holds the power as to how many loans can be given out is the country’s central bank.

Central banks hold the power over the commercial banks and the economy’s money supply. So if a central bank believes that too many loans are being given and they believe that inflationary pressures may start increasing, a central bank can start to enact contractionary monetary polices to slow don’t the rate at which commercial banks can loan out money. The power as to how many loans can be lent out lies with the central bank. Don’t forget that.

Now I bet you’re wondering what the bad side of loans are, huh? Well, allow me to clarify first. If you are the one lending the money to a borrower, then loans are mostly never bad, aside from the occasional defaults that may happen from time to time. But if you are the borrower, then loans have a bad, almost evil side to them. What is it? Borrowers of loans take on debt.

Debt Cartoon

The evil side of loans is that a borrower takes on debt. Debt, if not carefully managed, can ruin your life.

Borrowers of loans take on the a debt that is owed to the lender. If a borrower doesn’t carefully manage ones debt and budget accordingly, then debt can ruin the life of the borrower. Remember the example I mentioned earlier about you owning an automotive manufacturing business? Now imagine that you received the loan to purchase the automatic welding machines and all of a sudden business went bad. With business going bad, you start running short on money and as a result, you are finding it harder to pay your debts and your employees.

So what do you? Well, can fire some employees or request another loan. And that’s where the danger lies. If you opted to take on more loans for whatever reason, the debt incur can become to great of a burden to bear. Your debt may start getting out of control to a point where you are no longer able to pay back what you owe. Not paying what you owe can destroy a business, ruin families and lead to poverty. Yes, loans can and do lead to positive growth in an economy, but they can also lead to economic destruction.

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