Saturday, May 16, 2009

Understanding a Loan

What is a Loan and What is an investment?

This is very important that you ask yourself "Am I lending my money or am I investing it?". A lender typically requires the payment of interest and the return of the principle amount he lent out.

What is a Loan?
Usually, a borrower must give a collateral to the lender to secure the loan. Banks would normally ask for cash real estate collateral equal to 170% of the loan amount. Understand that a responsible bank does not give out loans just because there is adequate collateral.

The only correct basis for the grantingof loans is the ability of the borrower to prove that he will use the proceeds of the loan in an activity that will produce sufficient income to repay the loan.

To make sure the lender gets his money back, he only gives out when:
  1. The borrower has more than enough sustainable income to pay the load plus the interest.
  2. The lender really does not mind foreclosing on or taking over collateral.
If you want to be a successful lender in the future, you should follow this practice. Never lend money just because there is good collateral, unless you want that collateral at the price of the loan you gave. Just make sure you know that the price of collateral depreciates in value over time.

How about an Investment?
Investing in a company effectively makes you a partner in the business. The money that you put in as investment or capital is called equity (yeah you learned this word). This equity, whatever the amount, will be at full risk. Simple. You make money when the business makes money and you lose money when the business loses money. In investing, usually the institution/s offering such investment products do not guarantee earnings and return of the principal. They make best estimates based on extensive financial and operational studies conducted by reputable professionals.

Usually, the value of your investments rises or falls, depending on the profitability of the business you invested in. However, there is an added risk in the stock market. The values of the best stocks in the market fluctuate. These could go up or down, sometimes based on rumors, sometimes based on facts. So, you can never be 100% sure that you will earn money. The selling price (real value) of a stock is ultimately dependent on the investing public. Later I will tell you what stocks to invest in to earn money!

When you invest in shares of stocks that aren't listed on the stock market, the ability to take out your money is somewhat limited. There is no established way to withraw your investment when you need it (another reason to keep an emergency fund). Generally, you become dependent on the controlling shareholder and/or the management if you want to sell your investment.

Each private investment transaction is unique. Each one is different from the other. If you invest in a private offering, you must make sure you understant:

  1. How income is generated
  2. Who else is investing on this business
  3. How can you get back your investment when you need your money back.
Just remember these and your money will be safe. Later, I will talk about index mutual funds that generate good returns. So stay tune here in Compound Savings interest for more investment tips.


  1. I dont think I have ever seen a better explanation of the differences between a loan and an investment on the internet. I am 'challenged' when it comes to all this financial mumbo jumbo, however I understood this clearly. Keep up your writing style, it is very easy to comprehend.

  2. Thank you very much. I believe that everyone should be financially literate even just for a little bit. It helps us take control of our income and saves us from a very uncomfortable retirement.

  3. Great information here on your blog! Please visit mine one of these days, we some similar interests. :)

  4. Loan and Investments are things that everyone should be aware of. A very clear explanation. Good post!