Common Terms in Loan Agreements - Parties: The people who sign the loan agreement - Principal: The amount of money the lender loans the borrower, which the borrower must repay eventually. - Interest: In addition to repaying the principal, interest is the money that borrower must pay to the lender just for the privilege of borrowing. The amount is determined by the interest rate (percentage). As a cultural point of interest: some find it unethical to charge interest, especially compound interest, but according to Wikipedia (2009): “Compound interest predominates in finance and economics, and simple interest is used infrequently." http://en.wikipedia.org/wiki/Compound_interest. To see the difference between these two in practice, try this simple calculator: http://www.moneychimp.com/features/simple_interest_calculator.htm - Interest Rate: This is the percentage (such as 5%) used to calculate how much interest the borrower owes. Simply multiply the interest rate times the principal and you arrive at the interest. For example, multiply 5% interest rate (.05 or 5%) times the principal amount of $100, and you arrive at the interest: $5. The borrower therefore owes $105. Cultural Point of Interest: The typical interest rate in America between friends is 0% - 5%. For a typical business loan it is between 5-10%. But for credit cards, interest can go as high as 25%. When considering the amount of interest, a good rule of thumb is to never charge more than credit card companies do. Otherwise, your loan may be deemed illegal (usurious). - Amortization: a fancy term for calculating interest. Amortization calculators are helpful tools to create payment schedules that you can attach to your loan agreement, so everybody knows exactly how much is due each month.
You can also schedule a balloon payment. Again, you'll want to use a calculator to get this right and make sure everyone is on the same page.
Unpaid Balance: the amount the borrower still owes the lender - Prepayment Penalty: Some contracts have a prepayment penalty to discourage borrowers from making early payments. A prepayment penalty is therefore the amount of money the borrower must pay just for repaying early. This penalty will never exceed the total amount of interest that would accrue during the loan period. - Maturity Date: This is the date the last loan payment is due.
Big Picture of Loans
Loans can be very dangerous, even when handled carefully. To quote Publilius Syrus (1st century B.C.), "Debt is the slavery of the free." Before this was Proverbs 22:7, “The rich over the poor ruleth, And a servant [is] the borrower to the lender." Modern history offers many examples of lending abuse between individuals, banks, and nations. It seems most people don’t even know that international financiers frequently fund both sides of the same war! For an in-depth analysis, I recommend the scholarship of G. Edward Griffin. Money is a form of social energy – empowering what it touches. Energy can enliven or destroy depending on its application. Therefore, both borrowers and lenders should be very careful to use their money in a sustainable manner, lest destruction befall not only themselves, but those around them as well. For a fascinating life story about money and energy, read about Nikola Tesla. Consider the exponential power of compound interest. It is said that if you invested a pound of gold at the time of King Solomon, at a mere 1% interest (compounded annually), the loan would be worth more money than exists in all the world. For an interesting history of lending, read: http://www.michael-hudson.com/articles/debt/CompoundInterest1.html