Chapter 1 How Loans Work
A loan, at its most basic, is borrowed money thatâs expected to be paid back in the future with interest (extra money). Loans usually come with more rules and features than this simplified version, but at heart, theyâre just promises to return something.
Every loan has two sides: a lender and a borrower. The lender gives something, usually money, to the borrower. The borrower agrees to give back what she or he borrowed plus a bonus (whether thatâs extra money, an extra goat, or five days of labor) for the lender.
Back before humans created money, they bartered to get everything they needed. Every trade was completed at once, and no one owed anything. As soon as the idea of currency came on the scene (long before actual currency appeared), all of that changed. The concepts of debt and credit began more than five thousand years ago, and theyâve continued to dominate the way people manage their money.
SHEEP AND SHELLS AND SHEAVES OF WHEAT
The idea of money showed up long before coins and paper currency. As far back as 9000 B.C.E., people all over the world used sheep and cows as cash. Some societies used cowrie shells, others used beads or feathers. People werenât out shopping with this âmoney,â though. They were using it to settle disputes and arrange marriages.
Copper Coins
Metal coins first appeared between 600 and 500 B.C.E. when Chinese craftsmen created âcowrie shellsâ out of copper and bronze. Those shells soon evolved into coins, normally threaded on strings so theyâd be easy to carry.
As societies solidified, merchants began to emerge. People began to purchase goods and services, with most purchases related in some way to farming. Very soon, customers fell into a buy nowâpay later pattern, and the concepts of credit and debt were born.
Enter Debt
The first sign of debt appeared in 3500 B.C.E. in Mesopotamia. Various merchants recorded debts on clay tablets, confirmed by borrowersâ personal seals. Merchants often used those debts as a form of currency to buy what they needed. Whoever ended up holding the ancient IOU got to collect the debt.
In about 1754 B.C.E., the Code of Hammurabi spelled out the rules regarding credit and debt. Instead of casual clay tablets, loans now required witnessed, written contracts. Loans now carried interest, and the code set strict interest rate caps (for example, interest on grain could not be more than 33 percent). Borrowers could pledge property to assure lenders that their debts would be paid. These early forms of collateral included:
- Land
- Houses
- Livestock
- Family members
When borrowers could not pay their debts, such as a farmer whose crops were wiped out in a flood, they often fled their homes. That became so common that kings sometimes offered general amnesty for debtors, giving land back to those borrowers who couldnât pay.
Ancient Credit Scores
By the time of ancient Rome, large amounts of money began to change hands and loans became part of everyday finances. Thatâs partly because carting around several tons of coins was impractical, and it was easier to transfer ownership of the coins and buy on credit. People borrowed funds to bankroll trade, finance farms, buy properties, and invest. The loans were carefully tallied and tracked in account books held by both debtors and creditors; each entry was called a nomen, basically a name attached to an amount borrowed.
Those books also kept track of delinquent borrowers, protecting lenders from those likely to default. A farmer who was considered âuntrustworthy,â for example, would have a hard time finding a lender to finance his next crop. This practice was the forerunner of modern credit scores, which rate a borrowerâs ability and likelihood to pay off debt.
DEBT GETS BIGGER
International tradeâmeaning trade among nations rather than the earlier practice of trade within statesâgained momentum during the 1500s. Individual countries developed more complicated financial systems to deal with the complexities of their economies and foreign trade.
National governments now needed to raise funds to finance expansion, trade, and wars. They turned to banks and then to the public to borrow money. Consumer borrowing began to expand as well, mainly through merchants extending credit to customers.
The First Modern Banks
Though technically banks have existed since the Roman Empire, the modern banks weâre familiar with today appeared along with economic development. Giovanni deâ Medici established the first bank in Italy in 1397. Other Italian banks cropped up, including the oldest bank still in existence today, Banca Monte dei Paschi di Siena, which has operated since 1472.
Banking systems spread slowly throughout Europe. In 1694, the British government formed the Bank of England to raise capital for its war with France. Nearly one hundred years later, in 1791, prompted by Alexander Hamilton, the Bank of the United States was established. That short-lived bank lost its charter in 1811 (it wasnât renewed by Congress), leaving the country without a central bank. The Second Bank of the United States had a similarly short run. It wasnât until 1913 that the nation would get a long-standing central bank, when President Hoover signed the Federal Reserve Act into law.
Consumer Debt Grows Like a Weed
For generations, people borrowed money to buy homes and bought goods from local merchants on credit. For many years, consumer debt was nothing to write about. But once the first universal credit card (Dinersâ Club) was introduced in 1950, consumer debt began to take on a different character. The first credit cards were actually charge cards, where any balance due had to be paid back immediately; you couldnât run a balance. By 1958, that changed when Bank of America introduced the first revolving credit cards (BankAmericard) in California. In less than ten years, that card went national, and people throughout the country began to build up credit card balances.
Because theyâre primarily written by big banks and lending institutions, loan agreements can be hard for borrowers to digest. Theyâre full of terms and conditions that may be unfamiliar, especially for first-time borrowers. Theyâre often very long and written in formal legal language (sort of like user agreements that most of us just scroll to the bottom of). Since these contracts affect your current and future finances, itâs important to read and understand every word before you initial and sign them.
LOAN AGREEMENTS
Loan agreements are contracts that exist to protect both parties (the borrower and the lender) when someone borrows money. The contracts spell out exactly what the parties have agreed to and detail each partyâs responsibilities. They also detail what will happen if either party doesnât fulfill their obligations and how any disputes will be settled.
People are used to dealing with loan agreements when they borrow money from banks or mortgage companies, but not so much when loans get personal. In those cases, though, putting something in writing can protect both your finances and your relationships.
Different Kinds of Loan Agreements
There are many different kinds of loan agreements, and they range from super simple to dizzyingly complex. The simplest of these can be written in just a few words describing the arrangement between the borrower and lender (âI owe Joe $50,â for example). The most complicated look like booklets, with dozens of pages detailing every facet of the loan.
Formal loan agreements are legally binding contracts between two (or more) parties. They typically cover fixed-payment loans, meaning the borrower has to pay the money back according to a schedule based on the terms specified in the agreement. Theyâre normally added into public records, especially when the lender has the ability to seize the borrowerâs property (called collateral) if they donât pay the money back as spelled out in the contract.
The simplest loan agreements are called promissory notes. They include everything from an IOU tossed into a poker pot to a one-page fill-in-the-blank form with simple payment terms. Promissory notes serve as proof that one person owes another money and promises to repay the money. They may or may not contain specific time limits or payment amounts, but they do create a paper trail for the loan, though they donât offer the same legal protections as a formal agreement. These are often on-demand loans, which means that the lender can call for repayment whenever they want as long as they provide reasonable notice.
Put It in Writing
Loan agreements donât have to be written, but itâs better when they are. Thatâs especially true of loans made between friends (who want to stay friendly) or family members. Written agreements can prevent arguments down the line (such as disputes over how much was borrowed in the first place). They can serve as proof that the money was loaned rather than gifted. If thereâs interest involved, the agreement can include how the interest is calculated and what portion of each payment goes toward interest. Bottom line: Whenever you borrow or lend money, put something in writing to protect both sides.
UNDERSTANDING LOAN LINGO
Loan agreements contain a mix of financial and legal terms, and that combo can be confusing when you donât speak either language. Even some terms you might be familiar with, such as interest and principal, can come with unexpected twists in this setting. Lenders will throw these terms around during the loan process and expect that you understand them. Before you sign any loan agreement, get familiar with at least the most commonly used terms.
The Basics
Every loan agreement comes with four main features:
- Original loan balance: the total dollar amount borrowed
- Interest: a fee charged for the privilege of borrowing money, usually described as a percentage of the outstanding balance
- Loan term: the length of time that the loan will be outstanding
- Payment: the amount of money youâll return to the borrower periodically (usually monthly), calculated based on the loan balance, interest rate, and loan term
These four pillars form the foundation of the vast majority of loan agreements, but they donât look the same from one agreement to the next. Even if youâre borrowing the same amount of money, the other terms may vary widely at different times and among different lenders.
Next-Level Lingo
Once youâve conquered basic loan terminology, itâs time for next-level language. Youâll find these terms somewhere in most formal loan agreements, and itâs important to know what they mean before you agree to them.
- Annual percentage rate (APR): the total charges you would pay (the cost of your loan) if you borrowed the full loan balance for an entire year, converted to a percentage and often used for comparative purposes
- ACH payments: letting your lender pull your monthly payments directly from your bank account
- Collateral: property that the lender can take and sell if the borrower doesnât pay the money back as required
- Mandatory arbitration: forces parties to resolve disputes privately through an arbitrator (a neutral judge) rather than through the court system; the arbitratorâs ruling is final
- Cosigner: a person who promises to pay the loan if the primary borrower doesnât make the required payments
- Amortization: a series of fixed principal and interest payments used to pay down a loan over a stated period of time
- Closing: the meeting where money (and possibly property) legally changes hands
- Prepayment penalties: fees charged to discourage borrowers from paying off their debt early
- Delinquency: missing a single payment due date
- Default: not making a specific number (varies by lender) of consecutive payments, which can lead to serious financial consequences for the borrower, such as seiz...