The new deal will keep the England Under-21 international at the club until 2013.
The 21-year-old has recently been linked with a move to Tottenham.
“Obviously, I’m delighted,” Loach told the club’s official website.
“These’s been a lot of speculation about me staying at the club but at the end of the day, I want to play games and I’m only 21.
“I’m at a great club with a great young management side which I ‘m sure will be here for a long time as well and if I can stay here while they develop and help me develop then it will be good.
“I want to continue to rack up games with Watford and that’s all I ever wanted to do.”