How do loans work: The basic concepts
It's commonly understood that taking a loan puts an obligation on the borrower for the lender until the amount is paid back to the lender. But do you understand the nuances of the working of loans? Here we share with you the basic concepts that you must know about loans.
Secured or Unsecured Loan
There are two types of loans - secured and unsecured. If you take a secured loan (like a home or a 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), there is no need to provide any security.
A useful tip to keep in mind when you take a loan is to understand whether it's 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 the term or the tenure of the loan. For instance, personal loans have the tenure of one to three years, car loans of three to five years and education loan of up to seven years. Depending upon the type of loan you are taking, the tenure of the loan depends on two 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 it is to get a long-term loan.
Income: If your income is low, you might find it tougher to get a loan for a longer tenure.
Equated Monthly Installments (EMI)
When you take a loan, you are obliged to pay the lender through EMIs. The recurring payments comprise of two parts:
Principal repayment. A part of your EMI goes towards repaying the face value of the total amount that you originally borrowed from the lender.
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.
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 amortisation. 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 the end use of the funds is. 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.
For most loans, there is a set schedule according to which you repay your loan using the EMI payments. There are three things you should be aware of:
Default. Untimely or irregular payments can bring you in the default category and affect your credit history. On the other hand, failure of payment of a home or car loan can also mean the lender taking over the legal rights for your house or car.
Change in EMI. If you have floating rate loan, your EMI amount is subject to change if interest rates change in the market.
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 per cent to 3 per cent penalty charge to the lender along with some administrative charges and fees for early repayment.
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 lakh. The bank asks his parents to act as guarantor to the loan. If Kumar is unable to pay back the education loan, his parents would then be liable to return the balance amount.
The authors are co-founders of iTrust Financial Advisors, an independent financial advisory service. (www.iTrust.in)