While you may have a high-paying job with all the necessary perks, you may not always have money at your disposal to do certain things or buy expensive things. In such cases, individuals and businesses opt to borrow money from lenders in the form of loans.
Loans are financial agreements where the lender gives a certain sum to an individual for a particular purpose and the borrower guarantees that they will repay the provided sum with additional interest. This process is called getting a loan from the bank or financing.
Typical loans have three primary components- the borrowed amount also known as the principal, rate of interest, and the duration of the loan also known as loan tenure. While most individuals seek out banks or a Non-banking financial company for a loan as they are trustworthy and bound by government policies, some individuals with lower credit scores can also get loans from online lenders.
Moreover, there are also various types of loans, each serving a specific purpose. Loans in banking are the primary financial products and help the bank earn revenue in the form of interest.
Are you also interested in getting a loan from the bank? In this blog, we will discuss how do loans work, the types of loans, how they work, and the various features of loans.
Let’s dive in.
- What is a Loan?
- The Process of Getting a Loan
- Types of Loans Available at Financial Institutions
- Components of a Loan
- Expert Tips for Loans and Financing
- Features and Characteristics of Loans and Financing
- Basic Eligibility Criteria for Getting a Loan From the Bank
- Final Words
- Frequently Asked Questions(FAQs)
What is a Loan?
In layman’s terms, a loan is a sum of money that individuals or companies borrow from banks or other lenders to financially manage a particular event. The borrower incurs a debt in getting a loan from the bank that they have to repay with interest within a given period of time(loan tenure).
They can be in the form of a one-time amount or an open-ended line of credit up to a specified limit. There are also various types of loans like secured loans, unsecured loans, personal loans, commercial loans, etc.
In some cases, the lender may also require a valuable asset as collateral to secure the loan and ensure that the borrower repays the loan amount on time. They can also be in the form of certificates of deposits(CDs), bonds, or 401(k).
The Process of Getting a Loan
If you are interested in loans and financing, here is how the loan process works-
- When you are in need of additional funds, you apply for a loan from a bank or any other financial entity.
- The borrower is required to share specific financial information like a reason for taking a loan, income history, Social Security number, employment history, and other information.
- The lender reviews the information and evaluates your Debt-to-income ratio to determine your creditworthiness.
- Based on your credit report, the lender either approves or denies the loan application. Note: The lender must always provide a valid reason in case the application is denied.
- If your loan application gets approved, both the borrower and the lender sign a loan agreement that outlines the details of the loan.
- After the agreement is signed, the lender credits the loan amount and the borrower must repay the principal amount in instalments with added interest for the duration of the loan tenure.
Note: Before the loan is advanced, both parties must agree to the terms of the loan agreement. If the lender requires collateral, it must be listed in the agreement. All other important information such as interest rate, tenure of the loan, and monthly or weekly instalments are listed in the loan agreement.
Types of Loans Available at Financial Institutions
There are various types of loans in banking available at financial institutions, each serving a particular purpose. For your convenience, we have categorized them based on purpose, security, and pledged assets.
Based on Security
Secured Loans
Secured loans typically require the borrower to provide a valuable asset in the form of collateral as security for repayment. If the borrower is unable to repay the loan or break the terms of the agreement, the lender reserves the right to use the collateral to recover the amount of the loan. These types of loans generally have lower interest rates when compared to unsecured loans.
Unsecured Loans
Unlike secured loans, unsecured loans don’t require any collateral. The bank evaluates the borrower’s credit history, credit score, and other information to determine their creditworthiness. These types of loans generally have higher interest rates as there is no way to recover the loan amount if the borrower defaults on their payments.
Based on Purpose
Personal Loan
As the name suggests, personal loans are taken for personal expenses. The purpose of personal loans can range from repaying debts, vacations, downpayment for a house, medical emergencies, etc. These types of loans require credit checks and are often provided based on the borrower’s past relationship with the lender and their credit score.
Home Loans
Home loans are specifically used to purchase a house, renovate an existing property, or purchase an unoccupied plot for construction. The property will be held by the lender until the completion of the loan tenure and the ownership will be transferred to the applicant when the loan is completely repaid with interest.
Education Loan
Education Loans are specifically offered to help the applicant pursue education. It can be used for various courses including an undergraduate degree, diploma/certificate, or postgraduate degree. These loans require the admission pass provided by the university and can be availed for both domestic and international courses.
Vehicle Loan
Vehicle Loans are provided to finance the purchase of a two-wheeler or four-wheeler. It can be used to purchase a new or second-hand vehicle. In vehicle loans, the loan amount is decided by the banks based on the on-road price of the vehicle.
Much like home loans, the vehicle is held by the lender until the loan is completely repaid with interest. Moreover, vehicle loans rarely provide 100% financing so it is best to arrange a downpayment to purchase the vehicle.
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Based on the Pledged Assets
Gold Loans
Like collateral in secured loans, many lenders also offer loans if the borrower pledges physical gold or other valuable jewellery. The loan amount is calculated by the lender by weighing the gold and conducting several purity checks, among other things. The money received can be used for any purpose including personal expenses.
Much like secured loans, the loan must be repaid within the duration of the tenure. If the borrower fails to repay the loan or defaults on the repayments, the lender reserves the right to use the gold or jewellery to recover the loan amount.
Loans Against Assets
Similar to gold loans, individuals can also pledge various valuable assets like property, mutual funds, bonds, certificates of deposits, and other assets to acquire a loan. The lender calculates the value of the pledged asset and offers a loan amount with some margin. The borrower is required to make repayments to rightfully acquire the ownership of the pledget asset. In case of repayment failure, the bank or the lender can sell the assets to recover the loan amount.
Components of a Loan
Each loan has several components that the borrower must properly understand.
Principal: The original amount of money that is being provided by the lender.
Loan Tenure: The amount of time in which the borrower must repay the loan with interest.
Interest Rate: The rate at which the borrowed money increases. It is usually displayed in the terms of an Annual Percentage Rate(APR)
Loan Payments: The amount of money that must be paid in equated monthly instalments (EMIs) to satisfy the terms of the loan. It is determined from an amortization table based on the principal, interest rate, and loan tenure.
Besides these, there are also hidden charges in the form of origination fees, servicing fees, late repayment fees, and more. Most lenders also require a valuable asset like real estate, jewellery, vehicle, or another asset as collateral for larger loans. In case of repayment failure, the collateral can be seized to recover the loan amount.
Expert Tips for Loans and Financing
While loans can help you finance your next vacation or house renovation, it can be hard to acquire a loan if you have a poor credit score or a history of defaulting on repayments. Here are some factors that are considered by the lender when evaluating a loan application-
Income: Some lenders require a particular income threshold for larger loans. This is to ensure that the borrower can repay the loan without any problems. They also evaluate your employment history and often favour stable employment, especially in the case of long-term home mortgages.
Debt-to-Income Ratio: Besides income, lenders also check your debt-to-income ratio to see how many active loans are running simultaneously. If you have a high DTI, your application may be declined as a high level of debt indicates that the borrower may struggle with loan repayments.
Credit Score: It is one of the most important factors to determine your loan approval and interest rates. A credit score is a numerical representation by FICO that displays an individual’s creditworthiness. It is calculated based on your history of borrowing and repayments. If you have prior default repayments or bankruptcies, it will negatively impact your credit score.
Collateral: Providing collateral ensures that the lender will be able to recover the loan even if you default on your repayments. The interest rate of your loan will also be decided based on the collateral you provide and its market value. Typically, loans involving collateral have lower interest rates and result in more trust between the lender and the borrower.
Down Payment: The down payment is also a deciding factor that lenders consider when evaluating a loan application. The higher the down payment, the lower is the required loan amount.
These are some of the most important factors evaluated by lenders when considering your loan application. It is important to prove your creditworthiness and demonstrate that you utilise debt responsibly to increase your chances of qualifying for a loan.
Avoid taking unnecessary debt and repay your existing debts on time to maintain your credit score. This will also allow you to get lower interest rates.
If you already have a weak credit history and poor credit score, you can still qualify for a loan with some lenders. However, these will certainly come with higher interest rates. These loans are quite expensive in the long run and should only be used as a last resort.
Read Also:- 5 Major Factors That Affect Your Credit Score
Features and Characteristics of Loans and Financing
- Based on various factors, there are various types of loans.
- You can choose to take a particular type of loan based on your eligibility and requirements.
- The final call for approving the loan lies with the lender. Moreover, they also decide various loan terms like the loan amount, interest rates, and loan tenure.
- Every loan has a repayment tenure and a fixed interest rate.
- The bank or financial institution charges various fees while processing a loan application.
- Many online lenders also provide instant loans that are credited in a few minutes or hours.
- The interest rates of the loan you wish to take are determined by your credit history and score.
- The lender has the right to determine the requirement for collateral.
- In some cases, lenders also accept a third-party guarantee instead of a collateral.
- The loan repayments must be made in Equated monthly instalments (EMIs) for the duration of the loan tenure.
- Some lenders also levy a penalty for prepayment of loans.
Basic Eligibility Criteria for Getting a Loan From the Bank
The eligibility criteria for getting a loan from the bank varies and depends on the type of loan you are getting. However, we have listed the basic criteria that you can use to check for eligibility-
- A decent credit score(580 and above)
- Regular Cashflow
- Age between 23 and 60 years at the time of applying
- Few valuable assets like FDs, property, investments, jewellery, etc.
- A good relationship and history with the bank
- A timely debt repayment history
- A low debt-to-income ratio
Besides these factors, the bank also requires certain documents when applying for a loan.
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Documents Required for Salaried Individuals
- Application form with a recent photograph
- Identity and Address Proof
- Social Security Number
- Bank statement of the last 6 months
- Latest income certificate
- Form 16
Documents Required for Self-Employed Applicants
- Application form with a recent photograph
- Identity and Address Proof
- Bank statement of the last 6 months
- Proof of business
- Business Profile
- Income Tax Returns of the last 3 years
- Profit/Loss Statement and Balance Sheet of the last 3 years
Final Words
A loan is a sum of money that an individual or company borrows from the bank. There are various types of loans in banking, each serving different purposes. They are the basic building blocks of the financial economy and one of the primary sources of revenue for most banks and financial institutions. Most banks offer loans with interest and allow individuals and businesses to fund their economic activities while being compensated for risk. Whether it is small personal loans or billion-dollar business loans, money lending is an essential banking function in our modern economy.
If you are also interested in acquiring a loan from the bank, you should self-assess various factors like your monthly income, expenses, credit history and score to ensure quick approval of your loan application. Remember, a decent credit score will get you lower interest rates which will be beneficial in the long run.
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Frequently Asked Questions(FAQs)
Ans. One of the best ways to reduce your total loan cost is to pay more than the minimum monthly payment whenever possible. This will reduce the amount of accumulated interest and allow you to pay off the entire loan early. However, it is recommended to be cautious as most lenders also charge a penalty for prepayment of the loan.
Ans. The 6 Cs of lending are as follows- character, capacity, capital, collateral, conditions, and credit score. These are the 6 most important factors that a lender uses to determine your creditworthiness and identify which financial opportunities offer the best benefits.
Ans. A loan shark is a slang term for predatory lenders who provide individuals with informal loans with extremely high-interest rates. They often target people with poor credit or no collateral. As the terms of the loan agreement are not enforced legally, loan sharks often resort to violence and intimidation to ensure repayment of loans. If you have a poor credit score, it is best to stay away from such lenders and find an authentic lender.
Ans. A loan is a form of debt incurred by an individual or a company. The lender- typically a bank or financial institution advances a certain sum of money to the borrower. The borrower agrees to certain finance charges including the interest rate, repayment date, and the loan tenure and signs an agreement to ensure repayment.
Most lenders also require collateral for providing loans. If the borrower fails to repay the loan or breaks the terms of the agreement, the lender has the right to use the collateral to recover the loan amount. These types of loans are called secured loans.
