Loan financing

The term loan financing legally refers to the provision of money or goods for a limited time. The money or the goods are provided by a lender (capital provider). The borrower usually has to repay the money received or the goods delivered via the loan to the lender, often with interest. Loan financing in a modern economy is ultimately made possible by the activity of central banks. In the Euro area, the ECB — European Central Bank — acts as the lender for commercial banks, which in turn can provide loan financing to private individuals, companies, the state, or other financers. Common examples or forms of loan financing in practice include overdraft facilities, mortgage loans, supplier credits, promissory note loans, acceptance credits, factoring loans, or bank guarantees. In some companies, financing is also realized through debt capital. This type of financing is called debt financing. Because the debt capital comes from outside and is not the company's revenue, this debt financing is also called external financing. If the capital comes from a company's revenues, it is referred to as internal financing. The origin of the capital is therefore decisive for the respective designation. For private individuals, every loan also counts as debt financing, since the capital also comes from outside. Compared to companies, where both external and internal financing are possible, private individuals therefore only have external financing.

Loan financings have the advantage that purchases can be realized more quickly when the needed money is not available. A disadvantage is, of course, the time commitment to the contract. The term and the installments are usually fixed and must be paid monthly. Another disadvantage can be taking on too many loans at once. However, one advantage can help here directly. By refinancing (debt consolidation), several loans can be combined and interest costs can be saved accordingly. Nevertheless, the borrower should always aim to keep an overview of all monthly costs for their loans in order to avoid falling into the debt trap.

Legal questions on loan financing

A loan financing arrangement is contractually governed by a loan agreement. According to this, the lender is obliged to make the agreed loan available to the borrower, while the borrower undertakes to repay the loan and to pay the agreed interest and fees. By granting a loan, the money or goods are generally made available for free use to the borrower. In most cases, loan financing takes the form of financing by a loan. A loan results in a transfer of use of money or goods from a lender (also capital provider) to a borrower. This usually transfers ownership of means of payment or commercial goods to the borrower. Unlike rent, lease, or borrowing, however, the borrower does not have to repay a loan by returning the same item or the same money that they received.

Different types of loan financing

Loan financings are viewed under numerous aspects and accordingly the possibilities to classify or distinguish them are diverse. A common distinction is according to the purpose and the form of provision of the loan. A consumer loan is intended to finance the purchases of a private individual, while investment loans are, for example, for corporate investments in fixed assets. If a working capital loan is granted, it serves to finance current assets or operating costs, while a bridge loan is granted to close a financial gap until, for example, a long-term investment loan is received. Import or export loans serve to finance trade transactions and a securities loan is used to finance securities purchases. When loan financing is distinguished by the form of provision, it is usually either a cash loan or a goods credit. Broad classifications of loan financing can also be made according to terms and loan volume. When categorizing loan financings by term, short-, medium-, and long-term loans are often distinguished. A loan term of up to six months is considered short-term, six months to four years is medium-term, and longer than four years is considered long-term. Loan financing can also be categorized by the amount of the loan volume. In addition to microloans, one knows small, medium and large loans, although the exact assignment of a loan is not made uniformly. Only a so-called million-loan is legally defined and refers to loans for which banks are required by law to demand special collateral. The type of collateral or the loan status is also often used to classify a loan financing. An unsecured loan (blank loan) has no collateral, while other loans may be partially or fully secured. The status of a loan is intact when interest and repayment are paid regularly. If repayment of a loan is doubtful, it is either endangered or already non-performing. A loan has defaulted when neither interest nor principal can be collected.

Risks and collateral in loan financing

Before almost every loan financing, the lender examines the credit risks. If the lender is a bank, there are various legal requirements according to which a credit check must be carried out. The borrower's creditworthiness and the assessment of the collateral offered to secure a loan are always examined. The lender pays particular attention to the borrower's ability to pay interest and principal from as secure, regular income as possible. Depending on the term, type and amount of the loan and the borrower's creditworthiness, additional securities such as mortgage charges, pledging of receivables or deposits may be required. Since the collateral necessary for loan financing can take many different forms, granting loans is almost always possible. For example, if the collateral is only partially sufficient to fully cover the credit risk, that does not necessarily mean that a loan cannot be granted. In such situations the lender's risk is indeed increased, but loan financings can still be made possible at higher interest rates when credit risk is elevated.

Lenders and borrowers

Loan financing is also often classified according to the lender. Thus one speaks, for example, of bank financing or bank loans, supplier credits, or loan financings by employers or private loans. Universal commercial banks are the most important lenders and grant practically all types of loans. Distinct from these are specialist banks such as mortgage banks, building societies for home financing, or banks specialized in consumer credits. Large retail companies or car manufacturers operate banks as subsidiaries that offer loan financing to promote sales of their own products. The public sector also runs specialist institutions such as the Kreditanstalt für Wiederaufbau and state development institutions to grant subsidies or subsidized loan financings for political reasons. For particularly large loans, several lenders often form a consortium to distribute risks in the context of a syndicated loan. Not only one credit institution can grant a loan. In the private sector, vendor financing between merchants and end consumers is widespread. Life insurance companies offer classic home financing that is repaid through life insurance savings. A particularly large share of private loans by non-banks is granted by credit card companies. Among traders, many goods are delivered with payment terms and loans from friends or relatives often make a loan financing possible in the first place. Loan financings are particularly often used by private individuals and there are therefore specific consumer protection regulations for loan financings to private individuals. Particularly common examples of loan financing to private individuals are overdraft facilities, installment loans for the purchase of consumer goods up to and including vehicles, home financing or guarantee loans for deposits. A loan financing for business customers is a transaction between commercial traders, so consumer protection rules do not apply here. In the commercial sector, besides the classic forms of loan financing, there are other types of financing. For example, companies can resort to various other capital market instruments such as selling parts of the company, whereby the boundaries between typical loan financing and other types of financing are fluid. Not to be forgotten are loan financings for the public sector, i.e., the federal government, the states, municipalities or state-owned enterprises, where special lending rules also apply. Another special form of loan financing is formed by loans that banks grant to each other, also referred to as interbank transactions.