Introduction to Banking
After working for 6 months, Satish wanted to buy a car. He had saved some money for the down payment. He now wanted to avail of a car loan. However, before approaching a bank, he decided to learn about loans and understand how they work.
What is a Bank Loan?
A bank loan is a fund advanced by the bank to its customers. In return, customers pay a certain sum of money to the bank as interest on the money. Banks can loan the money for a specific purpose such as a car loan to buy a car or they can provide funding for a general-purpose such as a personal loan that can be used for any purpose.
Every loan is provided for a specific time period within which the repayment has to be made. Customers pay back the principal and interest amount in installments which are known as Equated Monthly Installments or EMIs. Each EMI consists of a principal and an interest amount.
Satish wanted to avail of a loan of ₹ 500,000 to buy the car. He found that Kotak Mahindra Bank offers car loans at an interest of 8.5% per annum as of March 2019. He calculated that the EMI for 5 years will be ₹ 10,258.
Advantages and Disadvantages of Loans
It will be wise to have a look at the advantages and disadvantages of loans:
Advantages of Bank Loans
Cost-Effective: Among all the financing options, bank loans have the lowest interest rate. Instead of taking loans, customers can meet their financing requirements using credit cards or overdrafts from banks. However, the interest rate on them will be much higher than that in loans.
For example, a person looking for some funds for personal use can either opt to use his/her credit card or take a personal loan from a bank. However, he/she will have to pay an interest of around 2.5%-3.00% per month in case of a credit card as against a flat 12% (March 2021) per year interest on a personal loan taken from Kotak Mahindra Bank. Hence, the personal loan will work out to be more cost-effective.
Flexibility: Since at the time of taking a loan, the customer is aware of the EMI amount and the time period for which the repayment will continue, customers have the independence to plan their finances. Moreover, in the case of loans, the EMI amount is automatically debited from the savings account of the customer removing any hassle of manual payment.
Retaining Earnings: When it comes to running a business, loans are the best way to finance them. Since the company pays an EMI, profits can be retained by the shareholders.
Tax benefits: Certain loans such as home loans provide tax benefits to the borrower. While filing income taxes, customers can claim tax benefits on the interest paid on the home loan for that financial year.
Disadvantages of Bank Loans
Repayment Burden: Loans have to be repaid over several years. In some cases, this may be more than a decade as well. For example, typically a home loan is taken for 15 to 20 years and the EMI has to be repaid over the next 20 years. This might put a financial burden on the borrower.
Strict Requirements: Banks have very strict requirements regarding documentation before providing any kind of loans. Banks take a risk by giving out a part of their fund to a customer. Hence, it is imperative for them to conduct the necessary background check and be sufficiently satisfied regarding the repayment ability of the customer. For people who don’t have their documentation organized, this process might look tedious, even worrisome.