A loan is the purchase of the present use of money with the promise to repay the amount in the future according to a pre-arranged schedule and at a specified rate of interest. In banking and finance, loan contracts formally spell out the terms and obligations between the lender and borrower.
In 1999, commercial banks in the United States carried more than $3.3 trillion in loans and leases outstanding. More than 40 percent of these loans were for commercial and industrial purposes, including lending for construction and land development. General commercial and industrial loans on the books averaged approximately $950 billion during the first half of 1999, representing a 10 percent nominal increase from the year earlier period, as the relatively strong U.S. economy spurred banks to ease credit. This was in stark contrast to the early 1990s, particularly in the commercial real estate segment, when bank lending was extremely tight. The ten largest commercial lenders represent only between 10 and 15 percent of all business lending by value.
Based on selected short-term averages published quarterly by the Federal Reserve, the average business loan between mid-1998 and mid-1999 was approximately $750,000. The average duration of all business loans during that period was about one year.
The length of the loan contract is the time to maturity; therefore, loans vary according to maturity. Short-term debt is from one day to one year. Intermediate debt ranges from one to seven years. Long-term debt is more than seven years.
Revolving credit and perpetual debt have no fixed date for retirement. Banks provide revolving credit through extensions of a line of credit. Brokerage firms supply margin credit for qualified customers on certain securities. While the borrower may always be in debt, the borrower constantly turns over the line of credit by paying it down and reborrowing the funds when needed. A perpetual loan, on the other hand, requires only regular interest payments. The borrower, who usually issued such debt through a registered offering, determines the timing of the debt retirement.
Payments may be required at the end of the contract or at set intervals, usually on a monthly or semiannual basis. The payment generally consists of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, repaid little by little until completely retired. As the principal balance diminishes, the interest on the remaining balance also declines.
Interest-only-loans do not pay down the principal. The borrower pays interest on the principal loan amount and is expected to retire the principal at the end of the contract through a balloon payment or through refinancing.
Interest is the cost of borrowing money. The interest rate charged by lending institutions must be sufficient to cover operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of 3, 5 and 10 years. Floating rates are tied to some market index and are adjusted regularly.
Assets pledged as security against loan loss are collateral. The asset purchased by the loan often serves as the only collateral. For example, real estate or land collateralizes mortgages. In other cases the borrower puts other assets, including cash, aside as collateral. Credit backed by collateral is thus known as secured debt, while unsecured debt relies on the earning power of the borrower. Government survey figures suggest that around 40 percent of all commercial and industrial loans are collateralized.
A special commitment loan is a single purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a one-time increase in current assets, such as a special inventory purchase, an unexpected increase in accounts receivable, or a need for interim financing.
Trade credit is extended by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment.
A seasonal line of credit of less than one year is used to finance inventory purchases or production. The successful sale of inventory repays the line of credit.
A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Creditors expect future earnings to be sufficient to retire the loan.
Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year and less than five. Consumer loans for autos, boats and home repairs and remodeling are typically intermediate term.
Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run 10 to 30 years.
A bond is a contract held in trust with the obligation of repayment. An indenture is a legal document specifying the terms of a bond issue including the principal, maturity, date, interest rates , any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders. Corporations and government entities issue bonds in a form attractive to both public and private investors.
A debenture bond is unsecured. Mortgage bonds hold specific property in lien. A bond may contain safety measures to provide for repayment, such as a sinking fund.
As with all credit markets, loan accessibility varies greatly depending on the amount, the borrower's characteristics and purposes, and the general economic and competitive climate in the lending industry.
Traditionally, small businesses—especially those owned by women and minorities—have had a difficult time obtaining loans, even for fairly small amounts, such as under $100,000. For very small businesses, banks are usually more interested in the owner's personal credit history than in the company's, which can be an obstacle for some business owners. Smaller, community-based banks tend to be more willing to make loans to small start-up companies that aren't particularly capital intensive.
The U.S. Small Business Administration (SBA) runs several programs to make loans more available to small businesses, including special programs for firms owned by women and minorities. The typical SBA program loan is administered by a commercial lending institution, but the SBA guarantees at least a percentage of the loan (often 50-90 percent) against default.
In the mid-1990s there were hopes that a secondary market for business loans, including small business loans, would develop in the same way that the secondary market for residential mortgages has flourished. This would add stability to the primary market by distributing risk and ultimately increase the availability of funds to small business borrowers. The commercial mortgage segment has benefited greatly from this trend (see Mortgage Backed Securities). However, as of the late 1990s, for small business loans this effort had made only modest headway, as would-be investors found it harder to evaluate the riskiness of business loans than of traditional residential mortgages.
For larger and more established companies, banks are mostly concerned with the firm's finances, quality of management, and market prospects. Specific considerations may include credit history, assets and liabilities, cash flows, orders, inventories, accounting practices, management experience, marketing strategy, and the general market outlook for the company's products or services.
Medium-size and larger businesses often have a variety of alternative methods for raising capital instead of taking out loans. Normally businesses will seek to minimize their cost of capital by choosing the method that most reduces costs or risks based on the length of time and purposes they need the money for. The options include both debt and equity financing. The primary debt alternatives are issuing bonds and commercial paper, while equity financing entails selling shares of stock to investors, such as private investors, venture capital firms, or the general public through a public offering. As another alternative to loans, companies may wish to pursue joint ventures with other firms to reduce their level of investment in a project.
Federal Reserve. "Report to the Congress on Markets for Small Business and Commercial Mortgage-Related Securities." Washington, September 1998. Available from www.federalreserve.gov .
——. "Survey of Terms of Business Lending." Washington, 21 June 1999. Available from www.federalreserve.gov .
Fraser, Jill Andresky. "How to Finance Anything." Inc., March 1999.
"Top 10 Bank Holding Companies in Commercial and Industrial Loans." American Banker, 25 June 1998.