Banks don't make money by taking your deposits and holding onto them until you need the cash. They make money largely through loans. A bank loan is an arrangement in which a bank gives you money that you repay with interest. Loans are distinct from revolving credit accounts, such as credit cards or home equity lines of credit, which allow you to continually borrow and repay up to a certain amount.
Terms of a Typical Bank Loan
Any loan you get from a bank will require you to sign a contract, called a loan agreement, promising to pay back the money. The contract will spell out the specific conditions, or terms, of the loan. These include:
- The principal, or the amount you're borrowing.
- The interest rate the bank will charge on the loan.
- Whether you are offering any collateral for the loan. Collateral is property that the bank can seize if you fail to repay the loan. With mortgages and auto loans, the collateral is usually the home or car that you borrowed the money to buy.
- The repayment schedule. Usually, you'll make a series of payments over time, with each payment made up partially of principal and partially of interest. The repayment schedule could cover just a few months or years, as with a personal loan, or it could last for decades, as with a home mortgage.
The federal Truth in Lending Act requires banks to clearly explain the terms of the loan, including how much it will cost you in total interest. State laws may also set limits on how much a bank can charge in interest or other loan terms.
Interest on a Bank Loan
How Rates Get Set
Interest is the cost you pay for the privilege of using the bank's funds. Banks make money by charging interest on loans at higher rates than the interest they pay on deposits. The interest rate you pay on a bank loan depends largely on two factors:
- The overall cost of lending in the economy.
- How risky the bank thinks it is to lend money to you, specifically.
The first of these has nothing to do with you; it's determined by larger forces like the size of the money supply, overall demand for loans and a range of government policies. These affect the rates everyone pays. The second has everything to do with you. Banks look at your credit report and credit score to see how well you've managed debt in the past; they examine your current income and financial assets; and they look at whether you're putting up collateral. What they're trying to gauge is how likely it is that you won't pay back the loan. The lower the risk the bank thinks you pose, the lower the rate you'll pay. If you're a higher risk, you'll pay a higher rate — this is, if the bank doesn't simply reject your loan application.
What Happens If You Don't Pay
So long as you make your loan payments as required in the contract, your debt will shrink, and the loan will eventually be paid off. But if you default on the debt — that is, stop making payments — then you've got problems. Usually the bank will contact you to see if everything's all right and to remind you to pay according to the loan agreement. Miss several payments, and the bank will conclude that you have no intention of paying.
If the loan is secured, meaning you have collateral to pay the debt, the bank will seize the collateral, such as by repossessing a car or foreclosing on a home, and then sell it. If it can't sell it for enough to cover the amount you owe, the bank might be able to sue you for the difference, or sell the debt to a collection agency. If the loan is unsecured, meaning there's no collateral, the bank might go straight to suing, or turn it over to collections.