Close

	Receiver's Name:		*
	Receiver's Email:		*
	Your Name:		*
	Your Email:
	Your Message:

How Do Loans Work - Basic Concepts You Must Know

Its commonly understood that taking a loan puts an obligation on the borrower towards the lender until the amount is paid back to the lender. But do you understand the nuances of how loans work? Here we share with you basic concepts that you must know about loans.

Secured or Unsecured Loan

There are two types of loans - secured loans and unsecured loans. If you take a secured loan (like a home or car loan) you will have to provide a security (such as a house or a car) to get the loan. However, in an unsecured loan (such as when you use your credit card), you will not need to provide any security for the loan.

A useful tip to keep in mind when you take a loan is to understand whether its secured or unsecured, and when you are eligible to get the security back from the lender.

Tenure of the loan

When you take a loan, you get it for a certain period of time. This period is called term or tenure of the loan. For instance, personal loans have a tenure of 1 - 3 years, car loans of 3 - 5 years and educational loan of upto 7 years. Depending upon the type of loan you are taking, the tenure of the loan depends on 2 factors:

• Age: If you are in your 30s, you will be able to get a loan for a longer tenure. For instance, you can get a home loan of up to 20 years in your younger days. However, the closer you are to your retirement, the tougher you'll find it to get a loan for a long-term.
• Income: If your income is low, you might find it tougher to take a loan for a longer tenure.

Equated Monthly Instalments (EMI)

When you take a loan, you are obliged to pay the lender through EMIs. The recurring payments comprise 2 parts:

1. Principal repayment: Part of your EMI goes towards repaying the face value of the total amount that you originally borrowed from the lender.
2. Interest cost: The other part of the EMI is the amount that the lender charges you for the original face value of the loan. It is a percentage of the total amount of money you are borrowing.

Loan Amortization

Every time you make an EMI payment you pay down some of the loan (the principal repayment), and also pay for the cost of the loan (the interest cost). This results in a gradual reduction to the principal amount of a loan. This process of paying down the loan is referred to as the process of amortization. The EMI amount stays the same but over the tenure of the loan the amount of principal repayment and interest cost comprising the EMI changes across the life of the loan.

Restrictions on use of funds

Some loans restrict the purpose for which the funds can be used. For instance, home loans can only be used to purchase homes and car loans can only be used to buy cars. However, in case of a personal loan or a loan against property, there are usually no end-use restrictions on what you can use the money for.

When taking a loan, keep in mind what is the end use of the funds. Chances are there might be a special loan for that end use where the terms might be better than if you just took a personal loan which can work out to be quite expensive. So, if you want to educate your child, don't take a personal loan, because most lenders have a special category of educational loans available.

Repayment scenario

For most loans, there is a set schedule according to which you repay your loan using the EMI payments. There are 3 things you should be aware of:

1. Default: Untimely or irregular payments can bring you in the default category and affect your credit history. On the other hand, failure of payment for a home or car loan can also mean the lender taking over the legal rights for your house or car.
2. Change in EMI: If you have floating rate loan, your EMI amount is subject to change if interest rates change in the market.
3. Charges involved for lump sum payments: If you choose to make a lump-sum prepayment on your loan, you may have to pay a 1% to 3% penalty charge to the lender along with some administrative charges and fees for early repayment.

Guarantor

When you take a loan, you might be asked to have someone as a guarantor to that loan, in case you default on the loan. For instance, Kumar takes an education loan of Rs. 10 lakhs. The bank asks his parents to act as a guarantor to the loan. If Kumar is unable to pay back the education loan, his parents would be liable to return the balance amount.

Comments

Thanks for your comment