How Do Loans Work?


Quick Answer

Loans work by giving money or assets to a person who needs it, and the borrower repays the lender with interest, according to Investopedia. A loan can come in the form of a one-time transaction or an open line of credit with a set limit.

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Full Answer

A loan agreement usually stipulates a time frame in which the balance must be paid in full as well as a cap on how much interest the lender can charge, notes Investopedia. Typically, loans are specified in writing for both parties and can stipulate that the borrower provide some form of collateral. Lenders make money in the form of accumulated interest that the borrower must pay, and interest normally accrues on an annual basis.

Many institutions such as banks offer loans in the form of credit, reports BusinessDictionary. When loaning money, banks create purchasing power that they lend to borrowers in exchange for an annual fee in the form of interest. They do this based on the fractional reserve system, which is a monetary policy that allows banks to keep only a percentage of depositor's funds as cash reserves and loan out the remaining amount.

Default occurs when the borrower fails to repay the amount borrowed and the interest on that amount, explains the TheFreeDictionary. As a result of default, the lender can take legal action against the borrower and may be entitled to keep all of the collateral in addition to any property or assets the borrower may possess in order to recover the money lent and the interest that has accumulated.

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