What is Loan Contract? Definition of Loan Contract, Loan Contract Meaning and Concept
The loan contract is the document that stipulates the agreement by which a credit institution delivers an amount of money, denominated in a specific currency, to a natural or legal person. Said subject, in exchange, must return the financing within the agreed term, having to pay, in addition, financial expenses and commissions.
In other words, a loan agreement is the agreement by which a financial intermediary, usually a bank, delivers money to an agent in need. The latter undertakes to reimburse the amount received in an agreed period, and must also pay interest and other charges related to bank management.
There are several types of loans, but all tend to make their conditions clear in a contract signed by the parties involved in the operation.
It is important to note that the contract must specify what the purpose of the loan will be, as this will influence the risk of default by the debtor.
It is also worth mentioning that the loan contract can be formalized before a notary. This may be mandatory for certain loans such as mortgages, depending on the country's legislation.
Participants in the loan agreement
The participants of the loan agreement are the following:
- Lender or creditor : It is who grants the financing. As we mentioned previously, it is usually a bank, but it can also be a microfinance institution, such as a savings and loan.
- Borrower or debtor : It is who receives the financing. You agree to return the principal of the loan together with the previously agreed interest.
The guarantor can be considered as a third party, who is the one who undertakes to guarantee the repayment of the loan in the event of default by the debtor.
Elements of the loan agreement
Among the elements that a loan contract must contain we have the following:
- Principal: It is the amount that the creditor grants to the debtor. It can be delivered in one or more installments.
- Financing period: The term that the debtor will have to return the financing received.
- Interest rate : It is the rate that will be applied to the principal to calculate the interest to be paid. These represent the financial expenses that the debtor must pay to dispose of the money today. The rate varies depending on the different variables, such as the level of risk of the operation (the lower the probability of default, the lower the interest rate and vice versa) or the maturity period. The longer the period of indebtedness, the higher the interest rate and vice versa.
- Types of amortization: It refers to the financial amortization methods, that is, to the way in which the loan will be repaid, which can mainly be in one of the following ways:
- French method : Constant periodic installments, that is, the same amount is paid in all periods.
- Italian method : The repayment of the principal of the loan is constant. Interest decreases over time and, therefore, also each periodic installment.
- German method : It is a variant of the French system, but the difference is that the interest is paid in advance.
- English method : Only interest is paid periodically and, at the end of the financing term, the principal is returned.
Types of loan agreement
Loan contracts can be classified just like the types of credits. For example, depending on their purpose, they can be personal loan contracts (for a specific need at a certain time such as a trip), consumer, mortgage or business loans.
In the same way, depending on the type of support they have, they can be pledge credit contracts, with mortgage guarantee, unsecured (with no specific guarantee other than the promise of the debtor), etc.