# What is A Loan?

## What is a Loan?

A loan is a permission to use money that you do not own. When a person takes out a loan he is actually buying the right to use money that is not his. The payment for the use of the loan is called interest. The longer the loan is given, the higher the cumulative interest payments, which are usually paid monthly or quarterly, because this authority is given for a longer period of time.

The language of loans
It is important to understand the language of loans. I will start with the basic words one needs to know to take a loan.

Principle – the amount that will go into our account on the day the loan is taken. For example, if we wanted to get a loan of 10,000 NIS, then those 10,000 NIS are called a principal.

Interest – the payment for the right to use money that is not ours (the principle).

Example: If we take a loan of NIS 10,000 at an interest rate of 10%, then at the end of the year we will have to return NIS 10,000 on account of the principal and another NIS 1,000 which is the interest payment, for the right to lend the amount we took as a loan.

Central Bank Interest Rate This is the interest rate at which the Bank of Israel lends or borrows money to the commercial bank and it is determined by the Bank’s Monetary Committee. At the time of writing, the Bank of Israel’s interest rate is 0.25%.

Prime interest rate:

P interest rate determined in each bank based on the Bank of Israel interest rate plus a spread. Today the average margin is 1.5%. Each of the commercial banks determines the margin itself. When it offers banking products such as loans then it takes the prime P interest rate as a basis. That is, at the time of writing these lines the prime interest rate is 0.1 + 1.5 = 1.6%.

Interest payments on loans are in many cases P + x%.

For example: if the annual interest rate on a loan is P + 5.5% then the proposed interest rate on the loan is: 1.6 + 5.5 = 7.1% because the prime interest rate is 1.5 + 0.1 = 1.6%.

Spitzer Loan – The loan repayment is based on a fixed monthly payment throughout the loan period. At the beginning of the period, the interest component in each payment is high, and it decreases in each payment, and at the same time, the principal component in payments increases over time. (Excluding inflation linkage differences).

There are different types of loans that differ by the interest rate of loans and the duration of the loan and the frequency of principal repayments and interest.

Balloon loan – a loan that during its entire period only interest payments are paid, while the principal is repaid in full at the end of the period. Sometimes the interest is also paid at the end of the period. This is a very risky loan if it is not known in advance that a sum of money is supposed to come in just at the end of the loan period (Excluding inflation linkage differences).

The price of the loan is always a percentage of the total amount, called the principal.

Example of a balloon loan:

Suppose we took out a loan of NIS 10,000 for 5 years. The terms of the loan are that we pay an annual interest of 5%, and the principal, that is, NIS 10,000, we will return to the bank at the end of the period.

If we take the loan for five years, and we are asked to pay the interest on the loan at the end of each year. At the end of the period, we will also repay the principal i.e. 10,000 NIS. I.e. our cost of using money that is not ours is 500 times 5 i.e. 2500 NIS which is actually a quarter of the total loan amount.

## Conclusion

When a person takes a loan she buys the right to use money that is not hers. The payment for the use of the loan is called interest. The longer the loan is given, the higher are the cumulative interest payments because this permission to use other people’s money is given for a longer period of time.

Banks are the intermediary between those who have money and deposit it in a saving account and those who do not have money who are willing to pay for the permission to use other people’s money. The bank will always charge a higher interest rate from the borrower than he offers the person who gives up using her money for a given period of time in which she deposit the money in a saving account.