Updated July 10, 2023
Definition of Loan Capital
The term “loan capital” refers to the money that is borrowed and used for making investments, either personal or business. It differs from equity capital, the money invested by the company’s owners and shareholders.
Typically, the lenders of loan capital, either institutional or retail investors, provide the money for a fixed period and, in exchange, earn interest income. It is also popularly referred to as “borrowed capital.”
Example of Loan Capital
Let us take the example of David, who purchases a new house by making a down payment, which will come from his savings and proceeds from selling an old house. The cost of the new home is $500,000, and 20% of the purchase has to be paid in the form of a down payment, i.e., $100,000. So, the remaining cost of the new home has to be borrowed, which is $400,000 (= $500,000 – $100,000).
The additional money required to buy the new house has to come in the form of a mortgage, most probably from a bank. So, the house is acquired with equity or down payment and debt or loan capital. The cost to borrow the money will come at a monthly interest payment that David will have to pay in addition to the principal payment of the borrowed or loan capital.
Sources of Loan Capital
Although there are many possible sources some of the most sources are as follows:
1. Bank Loans
It is the most common source of loan capital. Bank loans can be further categorized into:
- Secured bank loans: The borrower has to provide an asset to the lender as collateral in this type of bank loan. If the borrower fails to repay the loan, the lender has the right to sell the asset and recover the loan. Therefore, the interest rates are relatively low as the lender’s risk is reduced significantly because of the collateral.
- Unsecured bank loans: The borrower doesn’t need to provide any collateral in this type of bank loan. So, the lender must carefully examine the borrower’s financial condition. The interest rates are higher as the lender has to assume higher risk in this case as there is no collateral asset against the loan.
2. Bonds
It is a type of secured financial instrument that assures the lender/ investor that the borrower will repay the borrowed amount after a fixed period and make regular interest payments until repayment of the entire amount.
3. Debentures
It is an unsecured financial instrument backed by the borrower’s creditworthiness instead of any other asset. Debentures are assigned ratings based on the borrower’s financial stability.
How to Find Loan Capital?
There are many ways to borrow capital, such as bank loans, overdrafts, credit cards, bonds, etc. In all cases, a borrower can access a loan capital only by paying interest or coupon payments. Sometimes, the borrower might also need to provide an asset as collateral. It is backed by collateral that is considered to be secured.
Advantages of Loan Capital
- The borrower gets access to the money for business or personal use without transferring the ownership of the subject asset.
- The borrower doesn’t have to give away any decision-making right to the lender, which happens in the case of the option of equity.
- Since both principal repayment and interest payments are decided upfront, the borrower can easily plan future expenses accordingly.
Disadvantages of Loan Capital
- The borrower has to make the principal repayment and interest payments on a fixed date decided at the time of the loan. It is not subject to any condition, such as a good situation or not. Failure to meet the obligations results in default.
- In the case of pledged assets, the borrower can’t sell off the assets to any other third party until the entire loan amount is repaid.
Key Takeaways
- Loan capital is money borrowed from others, whether a bank or retail investor.
- Typically, it is used to invest, either personal or business.
- In the case of a company, loan capital is the opposite of equity capital, which is the contribution of the owners and shareholders of the company.
- It is usually raised through bank loans, overdrafts, credit cards, bonds, etc.
- The cost of loan capital is referred to as the interest rate.
- The borrower gets access to funds without transferring ownership of the subject asset or sharing any decision-making rights.
- Failure to meet repayment obligations of a loan capital results in default.
Conclusion
So, it can be seen that loan capital is one of the fundraising options used by individuals and businesses alike. However, while funding through equity infusion, retained earnings, etc., is considered internal sources of funds, money raised using debentures, bonds, bank loans, etc., is considered external sources of funds. Therefore, the borrower has to bear a cost for such external capital, which is popularly known as the interest rate.
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