Types of Loans
Loans can be a lifesaver, isn't it? Be it buying a new home or going for a world tour, or completing higher education from the best colleges – loans help us make our dreams come true. In this module, we will cover all the basic concepts associated with loans and talk about the types of loans available in India and things that you should keep in mind while applying for a loan.
What is a loan?
A loan is a sum of money that one individual/business/company borrows from another individual/business/company to meet any planned or unplanned financial requirement. The party that gives the money is called the lender and the party that receives the money is called the borrower. By taking a loan, the borrower incurs a debt that he has to pay back along with interest. The interest rate is pre-decided and is levied at periodic intervals (for example, monthly, yearly etc.)
In other words, when Mr Khanna lends ₹10,000 to Mr Sawant for a year at an interest rate of 14%, Mr Khanna is the lender and Mr Sawant is the borrower. Mr Sawant has to pay back ₹ 11,400 (₹ 10,000 + ₹ 1,400 interest) to Mr Khanna after a year. This whole process is a loan.
While loans can be exchanged between two individuals, in this module we will discuss only bank or NBFC loans – i.e. when the lender is a bank or Non-Bank Financial Corporation (NBFC) and the borrower is an individual/business/company.
Important concepts regarding loans
Before delving into advanced topics, let us first discuss some basic concepts regarding loans:
1. Principal: Principal is the initial amount of loan given. In the above example, ₹10,000 is the principal.
2. Interest: Interest is the additional amount paid back by the borrower – ₹1,400 in the above example.
3. Interest Rate: The rate at which interest is calculated is called the interest rate i.e. 14% in the above example. It can vary depending on the type of loan and the loan principal amount. For example, the interest rates of personal loans will be different from that of car loans. Similarly, the interest rates for larger amounts of loan such as ₹2 crores and above can be different from smaller amounts.
There are mainly two types of interest rate:
- Fixed rate: This rate does not change throughout the time period of the loan (also called the term or the tenure of the loan).
- Floating rate: This rate can change over the term of the loan. The fluctuation is dependent on various market and economic factors. Change in floating rate can affect the tenure and the monthly installment of the loan.
But which one should you choose if given an option? Well, it is highly dependable on the situation and your risk profile. Let's discuss a few differences between the two:
4. Equated Monthly Installment or EMI: When total payment amount (principal + interest) is divided into equal sections which the borrower pays to the lender, then it is known as an EMI. In the above example, the total payment of ₹ 11,400 can be divided into 12 equal EMI of ₹ 950 each.
This is a very common terminology you will often hear with regards to bank and NBFC loans. The total payment plus the interest amount always has to be repaid by the borrower in EMIs to the banks.
5. Payment Schedule: It is as the name suggests – a schedule of payment. Since a loan is paid back over a period of time, a payment schedule is drawn while giving out the loan to keep things transparent between the lender and the borrower. EMIs and payment schedules go hand in hand. The payment schedule gives a list of the EMI payments to be made by the borrower.
6. Amortization: The process of spreading out the loan repayment into a series of fixed payments is called amortization. The payment schedule is drawn in such a way that the loan is paid back at the end of the specific period.
7. Moratorium: Sometimes, the lender may decide to grant a holiday period in a loan when the borrower does not have to incur the EMI payments. This is known as a moratorium. For example, during the 2020 coronavirus pandemic, several banks decided to grant a holiday period to help the common people bide the economic crisis.
8. Security/collateral: At times, the lender may ask for a guarantee before granting a loan which is known as collateral. This remains as a security to the lender so that in case the borrower defaults the loan, the lender can sell it and recover a part or whole of the loan.
For example, in the case of home loans, the house on which the loan is given remains collateral. Hence, in case the borrower does not pay back the loan, the bank or NBFC sells off the house and recovers the loan.
9. Loan eligibility: This reflects whether the borrower is eligible to take a loan. Banks analyse the financial health of a person to determine whether he/she is capable of repaying back the loan. Things such as borrower’s income and other financial liability are taken into account while assessing the loan eligibility of a person.
10. Default: When the borrower fails to repay the loan, then it is known as a default. This is not a favourable position for a buyer since a person faces various kinds of repercussions once identified as a defaulter.
Advantages and disadvantages of taking a loan
Loans come with several advantages such as:
- They help fulfill our goals and objectives faster.
- Loans from banks or NBFCs offer low interest rates and are highly regulated as well.
- Bank or NBFC loans are flexible. You can choose from a variety of tenure and loan types.
- Bank or NBFC loans can offer tax benefits. For example, the interest in home loans and educational loans are tax-deductible.
However, bank or NBFC loans have a few disadvantages too:
- They are granted to people with sound financial stature. It is difficult to obtain a bank or NBFC loan for someone who is recently starting off their financial journey or someone with poor financial records.
- You end up paying more than you borrow since you have to pay interest on the loan.
- Some bank or NBFC loans may also have high-interest rates.