A loan is a form of debt, where the lender and the borrower enter into a contract. The borrower initially receives an amount of money, known as the principal, from the lender. This money is paid back usually, but not always, in regular installments to the lender. The rate of interest for the loan, or loan rate, is the cost of borrowing the money from a lender. The loan rate is applied on the outstanding principal amount and is expressed as a percentage of the total amount of credit owed.
Loan rates can be either fixed or variable. In the case of a fixed rate loan, the rate at which interest is charged does not change during the term of the loan. In the case of a variable interest loan, the interest rate is linked to an underlying economic index and can change periodically, based on the movements in this economic index. Changing interest rates is an important tool of the monetary policy. It allows a federal government to control inflation and boost economic growth by affecting the demand for goods and services by the people and by companies.
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Interest rates differ, depending upon the type of the loan being sought, the security being provided and the credit history of the borrower. Loans such as mortgages, which provide the home of the borrower as collateral, are considered secure and are available at a lower rate of interest. Credit card loans are considered risky by banks and financial institutions, since there is no collateral provided by the borrower and the default rates are comparatively high. Hence, in the case of credit card loans, the rate of interest charged is much higher.
Timely repayment of loans without defaulting on monthly payments helps a borrower build up a good credit history and facilitates the approval of future loans at a lower rate of interest.
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