Understanding the mechanics of a loan

crop businessman giving contract to woman to sign

Many of us obtain debt financing during our lives. Whether it is a car loan, a home mortgage, a student loan or a line of credit, each loan comes with a set of terms which dictate how the loan behaves and the obligations of the lender and borrower. Understanding how a loan works helps to understand how that loan will function in relation to the asset (hopefully) that is being acquired with the proceeds of the loan. This article will overview the different aspects of a loan which are key to understand.

Collateral

This term refers to the asset that the bank can take if the borrower doesn’t pay back the loan. As an example, for a home mortgage, the collateral is the home itself. If the borrower misses enough payments, the bank will “foreclose” on the home, meaning they will take over the home and sell it to get their loan proceeds back. This is why people say “you don’t own your home as long as you have a mortgage, the bank does”.

Principal

This term refers to the proceeds of the loan which you borrowed that needs to be repaid to the bank. If you took out a $100,000 mortgage, you have borrowed $100,000 in principal. The principal is repaid over the amortization period of the loan (see below discussion).

Interest

This term refers to the profit the lender makes from lending the principal to the borrower. Usually referred to as an annual rate, the interest rate reflects the risk of repayment of the loan. This is why the cheapest interest rates are associated with home mortgages which are collateralized by a house, and the most expensive rates are for payday loans which come with no collateral at all and considerable risk of ever being repaid.

Term

The term of a loan is the period of time that the loan will be outstanding before it is due back to the lender. In Canada, people often take out “Five Year Fixed” mortgages. This means that the loan has a term of five years. At the end of five years, the bank has a right to call back the entire balance of the loan. In most cases the bank decides to renew the loan for a new term, but that means the first loan ends and a brand new loan is set up with a new interest rate, term and amortization.

Amortization

This is the period of time over which the principal of the loan is repaid such that at the end of the period the remaining loan balance is zero. Each loan payment you make to the bank, unless you have negotiated an “interest only” loan, is a combination of interest expense and repayments of principal. The payment stays the same over the term of the loan, but the payments components change each time. As the principal is repaid, each payment has a smaller component of interest because there is less principal outstanding to assess interest on. By the last payment of the loan at the end of its amortization, the vast majority of the payment will be principal repayment.

Prepayment Penalty

In some loans, the bank assesses a penalty to borrowers for paying back the loan early. This is usually the case with fixed rate loans where the lender has locked in the interest rate they earn on the loan, which may or may not be aligned with market rates. The theory is that a borrower will only repay the loan early if the interest rate on their loan is higher than they could otherwise borrow at. This means that if the lender gets their principal back earlier, they will be forced to re-lend it out at a lower rate, and therefore they assess the borrower a penalty to account for this. Variable mortgages usually have minimal prepayment penalties because their rates are tied to the market underlying rate (like Prime or LIBOR).

Recourse

Recourse is the concept that a bank wants more collateral than the specific collateral that the loan is secured by, sometimes in the form of a personal guaranty or otherwise. More common in commercial lending where there is considerable risk to the loan, recourse is risk to the borrower that if they default on their loan and the underlying collateral is insufficient to pay back the loan, the lender can come after the borrower’s personal asset to get repaid.

Debt Service Coverage Ratio

This is a ratio that the bank calculates to determine the income of the borrower and the asset that collateralizes the loan against the debt payments to determine whether the borrower is generating enough income to repay the loan interest and principal. If a borrower has a house worth $1,000,000 and takes out a 30 year mortgage for $800,000 at a 3% interest rate, the payments are $3,372 per month. If the borrower only has income of $3,000 per month, the bank will not do the loan even if the house is sufficient collateral, because the borrower can’t afford the payments and the bank will likely have to foreclose on the house to get their money back. You want to have income significantly higher than the debt payment to prove you can pay the payments each month. For personal loans you don’t want your debt payments to be more than 35-40% of your take home pay.

Example Loan Amortization

Leave a Reply

%d bloggers like this: