Loans – Meaning, How They Work, Types, and Features

We may not always have the money we require to do certain things or to buy certain things. In such situations, individuals and businesses/firms/institutions go for the option of borrowing money from lenders. 

When a lender gives money to an individual or entity with a certain guarantee or based on trust that the recipient will repay the borrowed money with certain added benefits, such as an interest rate, the process is called lending or taking a loan.

A loan has three components – principal or the borrowed amount, rate of interest and tenure or duration for which the loan is availed. 

Most of us prefer borrowing money from a bank or a trusted non-banking financing company (NBFC) as they are bound to the government policies and are trustworthy. Lending is one of the primary financial products of any bank or NBFC (Non-Banking Financial Company) offers.

Types of Loans

Based on the Security Provided

Secured Loans

These loans require the borrower to pledge collateral for the money being borrowed. In case the borrower is unable to repay the loan, the bank reserves the right to utilise the pledged collateral to recover the pending payment. The interest rate for such loans is much lower as compared to unsecured loans.

Unsecured Loans

Unsecured loans are those that do not require any collateral for loan disbursement. The bank analyses the past relationship with the borrower, the credit score, and other factors to determine whether the loan should be given or not. The interest rate for such loans can be higher as there is no way to recover the loan amount if the borrower defaults.

Based on the Purpose

Education Loan

Education loans are financing instruments that aid the borrower pursue education. The course can either be an undergraduate degree, a postgraduate degree, or any other diploma/certification course from a reputed institution/university. You must have the admission pass provided by the institution to get the financing. The financing is available both for domestic and international courses.

Personal Loan

Whenever there is a liquidity issue, you can go for a personal loan. The purpose of taking a personal loan can be anything from repaying an old debt, going on vacation, funding for the downpayment of a house/car, and medical emergency to purchasing big-ticket furniture or gadgets. Personal loans are offered based on the applicant’s past relationship with the lender and credit score.

Vehicle Loan

Vehicle loans finance the purchase of two-wheeler and four-wheeler vehicles. Further, the four-wheeled vehicle can be a new one or a used one. Based on the on-road price of the vehicle, the loan amount will be determined by the lender. You may have to get ready with a downpayment to get the vehicle as the loan rarely provides 100% financing. The vehicle will be owned by the lender until full repayment is made.

Home Loan

Home loans are dedicated to receiving funds in order to purchase a house/flat, construct a house, renovate/repair an existing house, or purchase a plot for the construction of a house/flats. In this case, the property will be held by the lender and the ownership will be transferred to the rightful owner upon completion of repayments.

Based on the Pledged Assets

Gold Loan

Many financiers and lenders offer cash when the borrower pledges physical gold, may it be jewellery or gold bars/coins. The lender weighs the gold and calculates the amount offered based on several checks of purity and other things. The money can be utilised for any purpose. 

The loan must be repaid in monthly instalments so the loan can be cleared by the end of the tenure and the gold can be taken back to custody by the borrower. If the borrower fails to make the repayments on time, the lender reserves the right to take over the gold to recover the losses.

Loan Against Assets

Similar to pledging gold, individuals and businesses pledge property, insurance policies, FD certificates, mutual funds, shares, bonds, and other assets in order to borrow money. Based on the value of the pledged assets, the lender will offer a loan with some margin at hand. 

The borrower needs to make repayments on time so that he/she can get custody of the pledged assets at the end of the tenure. Failing to do so, the lender can sell the assets to recover the defaulted money.

Important Factors Lenders Look at to Approve your Application

• Credit Score

Credit score plays an important role in deciding whether the lender would like to go ahead with your application or drop it off at the initial stage. This is especially the case when it comes to unsecured loans.

Since a credit score represents the credit history of the borrower, the lender analyses the repayment history of the borrower and concludes whether the borrower can repay on time or will he default on payments. The loan approval is based on the lender’s judgement after the necessary analysis.

• Income and Employment History

Your monthly or annual income and employment history plays a crucial role in loan approval as well. Based on your income and income stability in the form of consistent and stable work history, the lender may or may not get convinced that you will be able to repay the loan.

Even if you are self-employed, the lender assumes that your business is running well for the past few years and your business’s turnover is satisfactory.

• Debt-to-Income Ratio

Not just having a good income, your debt-to-income ratio is also important. In case you have an income of Rs.1 lakh per month and if your debt repayment commitments exceed Rs.75,000 already, a new loan will not be provided to you as you will need the remaining income to take care of your domestic expenses.

Therefore, irrespective of your income, you must have a low debt-to-income ratio so the lenders can think that you have enough cash at hand every month to make the repayments as well as handle the family expenses.

• Collateral

Based on the collateral you provide and its current market value, the lender may decide on the interest rate applicable to your loan. Providing collateral will make the deal more secure from the lender’s perspective, which may result in more trust and less interest rate. An unsecured loan is infamous as it includes a higher interest rate comparatively.

• Down Payment

The money you have saved and the effective execution of your saving plan towards a down payment will increase the lender’s trust in you. The higher the down payment, the lower is the loan amount requirement. 

Features and Benefits of Loans

• There are several types of loans categorised based on various factors.
• You can choose the type of loan you wish to take based on your requirement and eligibility.
• The lender will be the ultimate power to decide the loan amount they wish to offer to you based on several factors, such as repayment capacity, income, and others.
• A repayment tenure and interest rate will be associated with every loan.
• The bank may apply several fees and charges to every loan.
• Many lenders provide instant loans that take a few minutes to few hours to get disbursed.
• The interest rate is determined by the lender based on the Reserve Bank of India’s guidance.
• The lender determines the requirement for security.
• A third-party guarantee can be used instead of security in some cases.
• The loan repayments must be made in equated monthly instalments over the pre-determined loan tenure.
• There may or may not be the option for full/part prepayment.
• Some loan types and lenders may levy a penalty for prepayment of loans.

Eligibility for Loan

The eligibility criteria to get a loan varies based on the type of loan you are looking for. Generally speaking, you may consider the following simple criteria to check your eligibility.

• A decent credit score
• Constant income flow
• Age between 23 years and 60 years at the time of entry
• A few assets such as FDs, investments, immovable property, etc.
• A good relationship with your bank
• A timely debt repayment history

Documents Required

Salaried Applicants

• Application form with photograph
• Identity and address proof
• Last 6 months’ bank account statement
• Latest Salary Slip
• Form 16

Self-Employed Applicants

• Application form with photograph
• Identity and address proof
• Last 6 months’ bank account statement
• Proof of business
• Business profile 
• Income Tax returns (self and business) for the last three years
• Profit/loss statements and balance sheets of the last three years

Loan EMI Calculator

A Loan EMI Calculator is a handy tool to calculate the monthly amount payable to the lender as well as the total interest. To calculate the EMI applicable to your loan amount, all you need to do is enter the values for principal Amount (P), Time duration (N), and Rate of interest (R).

How to Apply for a Loan?

Applying for a bank loan is simpler than one would think. But before you apply for one, you should be aware of your financial situation, given you will have to pay back the loan amount later. 

You must first understand your needs and if you think it’s an ideal way out for you, you can either go to the bank and talk to the loan manager or steer past all that and apply online.

Step 1: Choose the lender you would like to borrow from based on your research and check for your eligibility.

Step 2: Visit the bank branch or their official website to apply for the loan.

Step 3: Submit or upload all the necessary documents and proofs.

Step 4: The bank will process your application and get in touch with you to inform their stand within the stipulated time frame.

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