What Is Lending in Banking and How Does It Work?

Banks are financial institutions that accept deposits and provide funds to borrowers. This dual function allows banks to act as intermediaries, connecting those with surplus capital to those who need it. Lending is a central operation for banks, generating revenue and supporting economic activity.

The Core Concept of Lending

Lending involves a financial institution providing money to an individual, business, or other entity. The borrowed amount, known as the principal, must be repaid over a specified period. Borrowers also pay interest, which represents the cost of borrowing. Banks generate income through these interest payments.

The process establishes a clear relationship between the bank (lender) and the borrower. This agreement is formalized through a loan contract, outlining the terms, repayment schedule, and conditions. Banks help individuals achieve personal goals and enable businesses to fund operations, acquire assets, or expand. This financial support contributes directly to broader economic growth and stability.

Common Types of Bank Loans

Banks offer diverse loan products for individuals and businesses. Consumer loans are for personal use, including personal loans, auto loans, and student loans.

Mortgage loans are for purchasing or refinancing real estate. These loans are secured by the property, which serves as collateral. If the borrower defaults, the lender has a claim on the property. Residential mortgages involve substantial amounts and long repayment periods.

For businesses, banks provide various loan options to support operations, growth, and investment. Business loans include lines of credit, term loans, and equipment financing. These loans help companies manage cash flow, fund new projects, or expand their infrastructure.

How Banks Make Lending Decisions

Banks evaluate an applicant’s ability and willingness to repay borrowed funds. A central component is creditworthiness, assessed by credit scores and detailed credit history. A strong credit history indicates a lower risk to the lender. Banks also consider the applicant’s debt-to-income ratio to determine if they can comfortably manage additional debt.

Income and employment verification are crucial. Banks verify an applicant’s stated income to confirm a stable source of funds for repayment. For secured loans, banks evaluate the value and quality of the collateral, which provides a means of recovery if the borrower fails to repay.

The loan’s stated purpose also influences the decision, as certain uses may be riskier. Banks assess the proposed use to align with their lending policies and risk appetite. The bank performs a comprehensive risk assessment to determine the likelihood of default, guiding approval decisions and terms.

Repaying a Loan

Once disbursed, the borrower makes regular payments over a predetermined period. Each payment consists of two primary components: principal and interest. Principal is the original amount borrowed. Interest is the charge for borrowing, calculated as a percentage of the outstanding loan balance.

Interest rates can be fixed or variable. A fixed rate remains constant, providing predictable payments. A variable rate fluctuates, often tied to a benchmark, meaning payment amounts may change. Most loans are structured with installment payments, where a consistent amount is paid periodically until the loan is fully satisfied.

Larger, long-term loans like mortgages often follow an amortization schedule. Early payments primarily cover interest, with a smaller portion reducing the principal balance. As the loan progresses, a greater share of each payment is allocated to the principal, gradually reducing the outstanding debt.