Juan:'Why do people borrow money from a bank?'
Peter:'They borrow money from a bank if they need or want to buy or pay for something and they don't have enough money to do it. The main way people borrow money is in a loan, where they borrow a fixed or set amount of money (e.g. £10,000). They have to pay it all back to the bank within a fixed amount of time (e.g. 2 years, 30 years etc...). Normally, people have to pay back to the bank some of the money they borrowed each month until they have paid the bank all the money that they owe them. This money people pay back to the bank each month for a loan is called a monthly repayment.'
Juan:'How much interest do banks charge on loans?'
Peter:'It depends on both the credit history of the person applying for a loan and how long they are going to repay it for.
Before giving somebody a loan, banks look at a report (called a credit history) which shows the history of the loans that the person both has had and still has to repay. If the person has had problems repaying/paying back loans in the past, then they will have a bad credit history and the bank will charge them a higher interest rate than somebody who has a good credit history (who has had no problems repaying loans in the past).
In addition, the interest rate a person has to pay also depends on how long the person is going to take to repay the loan to the bank. Banks charge people interest during the time they are repaying money for a loan back to them (e.g. 6% interest each year a loan is being repaid). So for a bank to make money, the interest rate would have to be higher for a loan where you repay it all over 6 months than one where you repay it all over 30 years. A loan used to buy a house, which is called a mortgage, normally has a low interest rate because it takes a long time to repay it (between 20 to 30 years).'
Juan:'And does the interest rate on a loan change while you repay the loan?'
Peter:'It depends on what type of interest rate your loan has. Some loans have a variable rate of interest, where the interest rate can go up and down because of the changes in inflation (one year it's 7%, the next it's 5%). Other loans have a fixed rate of interest, where the interest rate you pay on the loan stays the same until you have repaid all the loan.'
Peter:'There are also other ways that you can borrow money from a bank. A common way that businesses use to borrow money is called a line of credit. This is a special type of account where a bank agrees to give a business the ability to borrow money from them when they need to.'
Juan:'But isn't that a loan?'
Peter:'Not really, because with a line of credit a business is given an amount it can use/borrow (e.g. £7,000) if it wants to. The business can choose to borrow as little or as much of that money when it wants (e.g. it could use £5 or the full £7,000). It's more like a credit card than a loan (where you borrow a fixed amount).'
Juan:'Is a line of credit the same thing as an overdraft?'
Peter:'It’s very similar, but an overdraft is where the bank allows/permits its customers to use or withdraw more money than they have in their current/checking accounts when they want to. Whereas a line of credit is only given to business customers, overdrafts are normally given to both business and non-business customers.'
Juan:'So with both a line of credit and an overdraft, the customers can borrow as much money as they want from the bank?'
Peter:'No. The bank sets/gives an overdraft limit or credit limit (for lines of credit) on how much their customers can borrow from them. Which means a maximum amount of money they can borrow/use.'
Juan:'What happens if somebody withdraws or spends more money than the limit of the overdraft or line of credit?'
Peter:'It depends on the bank. Some banks won't allow them to withdraw or spend the money and tell them they have insufficient funds. Which basically means they don't have the money in their bank account or they have gone over their overdraft limit. Other banks will allow them to withdraw or spend the money, but then the customer will have to pay bank charges, which is extra money they have to pay to the banks. These bank charges can be very high.'
Juan:'And if you can't pay the money back to a bank that you have borrowed?'
Peter:'When a bank sees that a loan repayment is overdue, which means it hasn't been paid when it should have been and it is late, they will contact the person who has the loan or borrowed the money and ask them to pay it. Normally, the person will have to pay bank charges for the overdue repayment. If the person or company defaults on the loan, which means they can't or won't repay the loan to the bank, the bank will try different ways to try to get the money they have loaned/lent to them back. Not paying back/defaulting on a loan, will give the person or company a bad credit history.'