How Do Loans Work?
Today, it is common to avail of a loan to purchase things that you cannot otherwise afford like a home or a car. When used responsibly, loans can be quite beneficial. However, if you are not careful, you may end up in financial difficulties and a debt trap.
What is a loan?
Loans comprise three components, which include the borrowed amount also known as the principal, the rate of interest, and the repayment tenure.
When you borrow money from any lender like a bank or a non-banking financial company (NBFC), you agree to repay the principal along with the interest over the loan tenure. Read on to know everything about this credit facility.
How do loans work?
Having understood what a loan is, let us now understand how it works. When you borrow money, you need to not only return the principal but also pay the interest on it.
When you avail of a loan, you have to repay the money in equated monthly installments (EMIs).
The EMI comprises the principal and the interest components. During the initial loan tenure, the interest component is higher. However, as you continue paying the EMIs, a majority of the installment goes towards principal repayment.
Therefore, it is recommended to repay the loan early to reduce the total interest outflow during the tenure.
Different types of loans
Financial institutions offer different types of loans, which can be classified as follows:
Based on assets
- Gold loans
These are available by pledging gold jewelry or coins or bars. Based on the weight and purity of the gold, the lender will offer the principal amount, which can be used for any purpose.
Gold loans are repaid in monthly installments and if you fail to make payments on time, the lender reserves the right to take charge of the gold to recover the outstanding balance.
- Other assets
You may avail of a loan against other assets like fixed deposits (FDs), mutual funds, bonds, shares, and insurance policies.
The loan amount depends on the value of the pledged asset after deducting some margin. Failure to repay the loan on time can result in losing your asset.
Based on purpose
- Home loans
You may use the borrowed amount to purchase a completed property or build a home. These types of bank loans can also be used for home repairs or renovations.
The lender will create a mortgage on the property and the ownership will be transferred once you repay the entire borrowed amount and the interest.
- Personal loans
If you require emergency funds, you may apply for personal finance. There is no limitation on how the money can be used.
Moreover, the loan amount depends on your relationship with the lender and your credit score.
- Education loans
Student loans allow you to pursue education from a reliable university or institute. The lenders approve your application only if you are eligible for international or domestic studies and have an admission confirmation letter.
- Vehicle loans
You may buy a new or a used car or two-wheeler with vehicle loans. The amount depends on the price of the vehicle, and you may have to pay some amount as a down payment as most lenders do not sanction 100% of the price.
Moreover, you will get ownership of the vehicle when the loan is repaid in full.
Based on security
You will have to provide some collateral to avail of a secured loan. If you are not able to repay the loan, the lender can take charge of the security to recover the outstanding amount.
Generally, secured finance is available at a low rate of interest.
Based on certain factors like your creditworthiness, past relationship with the lender, and income, the lenders may offer unsecured loans.
Such loans do not require pledging any security; however, the interest rate can be higher than a secured loan.
Who can get a loan facility?
Some lenders may offer a loan only to existing customers while others may accept applications from all borrowers. Loans are available for salaried and self-employed individuals as well as companies.
The eligibility criteria vary from one financial institution to another and also differ based on the type of loan. However, some of the basic eligibility criteria are as follows:
- Credit score
This is an important factor that determines your loan eligibility. The credit score reflects your debt-related history.
If you have a clean credit history with on-time repayments and no delays or defaults, it increases your credit score and your eligibility for availing of a loan.
- Employment history
If you are in the same employment for a longer period, it shows income stability, which improves your eligibility. With a regular and stable income, the lenders can determine your repayment capability before approving your loan application.
- Down payment
Most lenders require you to pay some money as a down payment when you apply for certain facilities like a home or car loan.
The higher the down payment, the lesser will be the loan requirement and vice versa.
- Debt-to-income ratio
This ratio shows the amount of debt you have against your total income. If the ratio is higher, it negatively impacts your eligibility as the lenders may not be convinced that there is adequate surplus to repay the loan installments.
The type and value of the collateral also affect the loan amount and rate of interest.
Valuable security may considerably reduce the bank loan interest rate, which can save you a significant sum in the long term.
Key features and benefits of a loan
- You can choose the loan based on your requirements and eligibility.
- Based on various factors, such as your repayment capability, income, existing debt, and credit score, the lenders determine your loan eligibility and principal amount.
- Several financial institutions offer online loans, which are approved within a short period.
- Some lenders may allow you to offer a third-party guarantee in lieu of collateral.
- Certain loans can be repaid before the end of the tenure; however, the lenders may charge some prepayment penalties.
How to increase your chances of getting a loan
- Improve your credit score by making repayments on your loans and credit card bills on time.
- Check your credit report regularly to ensure there are no errors and rectify any mistakes without delay.
- Include a co-borrower to enhance your loan eligibility.
- Ensure you do not take too much debt that may put you in a liquidity crisis and jeopardize your financial stability.
Different fees and charges associated with loans
In addition to the interest cost, the lenders may levy other loan charges like:
- Processing fees
- Late payment charges
- Prepayment penalties
- Annual fees (commonly applicable for credit cards)
- Stamp duty and registration charges (often levied on home and vehicle loans)
Documents required for a Loan
Some of the common documents required to avail of finance or loans include:
- Income proof
- Identity proof
- Residential address proof
- Bank statements
- Income tax returns (ITRs)
- Salary slips
- Profit and loss (P&L) account statement and balance sheet (for self-employed professionals)
Things to keep in mind while applying for a Loan
It is simple and quick to apply for loans and it can be done online or offline. However, before you avail of any kind of finance, here are some things you should keep in mind.
- Required loan amount
- Rate of interest
- Loan tenure
- Processing fees and other charges like late fees and prepayment penalty
- EMI amount
It is recommended that you take time to conduct extensive research on loans offered by various financial institutions to make an informed decision.
Availing of loans is a convenient way to meet financial requirements. But remember that you need to repay the borrowed amount with interest, and if you fail to do so, it can negatively impact your credit score.
Moreover, in the case of secured loans, you also risk losing your assets.
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