Maryland Gov. Harry Hughes has decided to give the Peabody Institute, the nation's oldest music conservatory, a $7.5 million, three-year loan to allow the financially troubled school to remain open while it tries to rebuild its depleted endowment.

Under a plan approved by the finance committee of the State Board of Higher Education last week, the Peabody's directors would invest the state funds and use the income from the investments to make up a projected $1 million deficit in their current $4.2 million budget.

Sheldon Knorr, Maryland's commissioner of higher education, said yesterday that he talked to Hughes after the finance committee voted to recommend the plan, and the governor told him that he would agree to the loan.

Hughes' decision was made, according to one source close to the governor, in anticipation of a favorable vote by the full Board of Higher Education on the loan proposal. The board is scheduled to meet Jan. 3. The governor's approval of the loan plan, however, is subject to the consent to the state legislature.

Under the terms of the loan, all investments of the state funds made by the Peabody's directors would be subject to the approval of State Treasurer William James. Finally, the plan would commit the Peabody's directors to launch a three-year fund-raising drive to raise another $7.5 million for a permanent endowment.

Earlier this fall the school's directors asked the state to give them a $124-million, 12-year loan to meet projected deficits, which they feared would force them to close. In return, they offered to surrender the school's $4 million art collection to the state as a sign of good faith.

Reached at his law office yesterday, Richard W. Case, chairman of the Peabody board, said he had not heard of Hughes' decision, although he had discussed the proposed loan plan with state officials.

"If it's true, its good news," he said. "What the funds will do -- taken with the other economies which I'm sure can be made -- they will give us the chance to see if enough outside contributions can be raised to ensure the Peabody's existence."

Two years ago, the Peabody Institute was formally affiliated with John Hopkins University, a move designed in part to help the music school defray some costs. But the terms of the Hopkins endowment prohibit any expenditure of Hopkins funds to maintain other institutions such as Peabody.

The Peabody Institute, which was founded 122 years ago, has long been regarded as one of the nation's finest music schools, and has produced such artists as pianist Andre Watts and soprano Veronica Tyler.