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What Is Financing? - Definition & Types

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  • 0:02 What Is Financing?
  • 0:40 Present and Future…
  • 1:17 Financing Example
  • 2:25 Types
  • 3:17 Secured vs. Unsecured…
  • 4:12 Lesson Summary
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Lesson Transcript
Instructor: Paul Mckinney

Paul has been in higher education for 17 years. He has a master's degree and is earning his PhD in Community College Leadership.

People borrow money to purchase homes, cars, boats, or anything else they don't have the money for at the moment they want to make the purchase. In this lesson, learn what financing is, as well as different types of financing used every day.

What is Financing?

Financing means asking any financial institution (bank, credit union, finance company) or another person to lend you money that you promise to repay at some point in the future. In other words, when you buy a car, if you do not have all the cash for it, the dealer will look for a bank that will finance it for you. Upon approval, the bank will pay the car dealer the money for the car, and then they will send you a bill each month. The bank will lend you this money if you agree to pay interest on top of the money lent to you. In other words, financing is borrowing money with a promise to repay that money and some additional fee, or interest, over a period of time.

Present and Future Value of Money

Why do banking institutions loan money to people? It is simple: they want to earn a fee, or interest, for loaning out their money. For instance, someone could borrow $100 from a bank for one year at a six percent annual interest rate. At the end of that year, the borrower owes the bank $106. In other words, you can say that the future value of the $100 is $106, given a six percent interest rate and a one-year period. It follows, then, that the present value of the $106 the bank expects to receive in one year is $100 today.

Financing Example

John Bailey has decided to buy a new boat to take his family out on the lake. The boat dealer is selling the boat for $2,500. However, Mr. Bailey only has $500 saved for the boat. Mr. Bailey goes to a finance company and completes an application to borrow $2,000 so he'll have enough money to purchase the boat.

Once Mr. Bailey completes the application, the finance company reviews his request. They look at his credit report, which details everyone that Mr. Bailey has borrowed from in the past. They look at such things as: Did he repay the loans he had in the past? Did he make his payments on time? Does he owe others too much right now and should not be approved for additional funds? All of these are important questions that the finance company needs to know before approving Mr. Bailey's request.

If the loan is approved, the finance company will give Mr. Bailey the money he needs to buy the boat. Mr. Bailey will sign a promissory note, which is a legal document saying that he will repay the loan. The promissory note also details the loan interest rate, the repayment terms, the amount borrowed, and finally, any late fees if the loan becomes delinquent.

Types

There are three main types of financing that people use every day:

  • Revolving or Credit Card Financing: The issuer of the card, or the bank, creates a revolving account and grants a line of credit to the user, or customer. The customer can borrow money from the credit card for payment to merchants or receive a cash advance.
  • Mortgage Financing: A bank or mortgage lender will loan a large amount of money to a customer, typically 80% of the price of a home, and the customer must pay it back with interest. If the customer fails to pay back the loan, the lender can take the home through a legal process known as foreclosure.
  • Personal Loan: A personal loan is borrowing a sum of money from a financial institution for personal use. Individuals may use the money for almost anything. Some examples are a vacation, a car, home improvements or bill consolidation, etc.

Secured vs. Unsecured

Generally speaking, there are two types of financial loans. The first type is called a secured loan and the other is an unsecured loan. Let's look at detailed information on both loan types:

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