Loan types

The world of borrowing and lending is a complex one. Just because it is complex doesn’t mean that it has to be difficult to understand. There are many different types of loans, and understanding and recognizing their basic criteria is must have knowledge for both lenders and borrowers. Lenders in any industry have to be flexible in providing a full range of financial products to be competitive with other companies. It is imperative that they can analyze cash flow. They must also analyze their profits produced by different kinds of loans.

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There are many different kinds of situations that can be presented when taking out a loan. It is a common phenomenon that borrowers invest a massive amount of time on price shopping and lose the savings based on poor and uninformed decisions. Like most things, each type of loan has its pros and cons. In order to make the right decision the borrowers have to understand the offered financing options. This will allow them to arrive at the best possible solution for their financing needs.
There are three main types of loans that we will discuss in this article; self-amortized, balloon, and interest only. The first type, self-amortized, is the most common. A self-amortized loan is a loan in which the payments consist of both principal payments and interest payments. The way this loan is set up involves a payment system that will allow the loan to be paid off by the end of a scheduled term. If these loans have fixed interest rate, the borrower and the lender will be aware of how much each payment will be in advance. If the interest rate is not fixed, like an adjustable-rate mortgage, for example, the amount of periodic payments will be subject to change depending on the future interest rates.
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One of the most common types of self-amortizing loans is home mortgages. Not every mortgage will be self-amortizing, but most of them are. The next loan is the balloon loan. The most important feature of a balloon loan comes at the end of the payment term . At the end of the term, the borrower will be expected to make one payment that is usually quite a bit larger than their usual month-to-month payment. This allows the borrower to maintain a lower monthly payment . For a real-world example, let’s say borrower owes $200,000 at interest rate of 5% on your home. Borrower plans to pay this home off in three years. He could choose to pay about $5,994.18 each month. Instead he chooses a balloon loan, and you pay $3,000.00 each month. At the end of your three-year payment term, the borrower will be expected to come up with the balloon payment of $116,034.46. This would be the remainder of the principal that the borrower did not pay over the three-year period. This arrangement helped the borrower keep his loan payments low during the loan term but he had to come up with a lump sum payment at the end of his loan term.

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The last type of loan we will discuss today, and the most complex loan , is the interest-only loan. In an interest-only loan, the borrower will only pay the interest each month. They will not be putting any money towards the principal payment. Because the borrower is not putting any money towards the principal balance, it usually allows them to purchase a home that is much bigger than what they can otherwise afford. These interest rates are usually fixed for one, three, or five years. After that, they can convert into a more conventional loan , where the borrower is paying towards the principal balance. The goal for most home owners is to save enough money over the course of the interest-only loan to afford those principal payments, or to sell their home before they begin. This kind of loan possesses the biggest risk for both lender and borrower because lender does not have added security of diminishing loan amount.
Because of the complexity of this type of loan, let’s discuss another real world example. This time, the example will be a type of interest only loan. Let’s say borrower is receiving a $1,000,000.00 loan for his home. He pays a 6% interest rate and put no money down on this one million dollar home. Let’s say the annual interest amount is $60,000.00, making monthly payments $5,000.00. If the house appreciates 10% in one year, the borrower will stand to make $50,000.00. But what if the house goes down in price by 5%? The borrower will still have to make $5,000.00 monthly payments and the lender’s collateral is worth less than the loan amount of $1,000,000.00 . In industry term, this loan is called underwater loan and such reckless lending caused real estate financial meltdown in 2007.

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