Introduction
Borrowing a loan is a serious financial undertaking, and being familiar with loan terminology is essential in making wise decisions. Most borrowers, particularly first-time applicants, tend to be confused with the fine print of loan contracts because of intricate financial terminology. Misunderstanding these terms can result in surprise charges, increased repayment obligations, or challenges in debt management.
This guide is intended to define the most prevalent loan terms in easy-to-understand language so that borrowers can confidently go through the loan process. Whether taking a personal loan, home loan, car loan, or business loan, knowledge of these terms will assist in selecting the appropriate loan product and steering clear of financial missteps.
Key Loan Terms and Their Meanings
Principal Amount
The principal amount is the actual money borrowed from a lender. Interest or extra fees are not added to it. The repayment cycle includes paying the principal amount together with interest for the loan duration.
Interest Rate
Interest rate is the price paid for borrowing money from a lender, as a percentage of the loan. It decides how much more a borrower will pay over and above the original amount. There are two main types of interest rates
Fixed Interest Rate
A fixed interest rate remains unchanged throughout the loan tenure. This means the equated monthly installment also stays the same, making financial planning easier for borrowers.
Floating Interest Rate
A floating interest rate varies with market forces and changes in the benchmark lending rate. This can lead to fluctuations in monthly payments, which can be good if interest rates fall but might also mean larger repayments if rates rise.
Annual Percentage Rate
Annual percentage rate is a better overall measure of the price of a loan that adds not only the interest rate to it but other charges like administrative charges and processing fees as well. It better enables the borrowers to compare loans with one another.
Equated Monthly Installment
An equated monthly installment is the regular monthly payment by the borrower towards repayment of the loan. Every installment has both interest and principal components. The interest paid in the early months is more, and the repayment of the principal increases with time.
Loan Tenure
Loan term is the time for which a loan is repaid by the borrower. The term may be just a few months or up to a few years. The longer the term, the lower the monthly payment but the larger the interest to be paid, and vice versa.
Credit Score
A credit score is a three-digit number that reflects the creditworthiness of a borrower. It is usually between three hundred and nine hundred. The higher the credit score, the lower the risk for lenders and the better the prospects of loan approval at reasonable interest rates. The credit score depends on the payment history, credit utilization ratio, and credit history length.
Collateral
Collateral is a property that the borrower promises to give as security for a loan. In the event of default, the lender is allowed to take the collateral to cover the amount owed. Collateral-based loans are referred to as secured loans, and they differ from unsecured loans, which do not require collateral.
Prepayment and Foreclosure
Prepayment is prepaying more amounts towards the loan principal amount ahead of time before the stipulated repayment date, thus minimizing the burden of interest. Foreclosure happens when a borrower makes full repayment of the loan well before the last date of tenure. Certain lenders have prepayment or foreclosure charges, and it is always prudent to read through the conditions first before prepaying.
Processing Fees
Processing fees are non-recurring charges made by lenders for loan application processing. Processing fees differ from lender to lender and are typically non-refundable, even if the loan application is declined.
Loan-to-Value Ratio
Loan-to-value ratio is the ratio of the loan value to the overall value of the asset financed. For instance, if a borrower avails a home loan of forty lakh rupees against a property worth fifty lakh rupees, the loan-to-value ratio is eighty percent.
Debt-to-Income Ratio
Debt-to-income ratio quantifies a borrower’s total debt payments each month against his/her monthly income. The lenders employ this ratio in order to judge repayment capability. A smaller ratio reflects improved financial health and a higher chance of loan sanction.
Default
Default happens when a borrower does not make the loan payments as scheduled. Default on a loan can result in penalties, legal proceedings, and a negative effect on the credit score, which makes it hard to secure future loans.
Moratorium Period
A moratorium period is a temporary halt in loan repayment, typically for education loans and some home loans. The borrower is not expected to pay during this time, but interest might continue to accrue.
Guarantor
A guarantor is an individual who undertakes to repay the loan in case the borrower defaults. Lenders can ask for a guarantor for risky loans or borrowers with poor credit history.
Hypothecation
Hypothecation is a legal right held by the lender on an asset taken on finance through a loan. For example, in case of a car loan, the car will remain hypothecated to the bank until the borrower repays the loan amount completely.
EMI Bounce Charges
When the EMI payment of a borrower is not honored because of an insufficiency of funds in his/her account, lenders levy an EMI bounce fee plus late payment fees. This reflects adversely on the credit rating of the borrower.
Sanctioned Loan Amount vs Disbursed Loan Amount
The sanctioned loan amount is the overall amount approved by the lender as per the borrower’s eligibility. The disbursed loan amount is the actual amount paid into the account of the borrower after adjusting processing charges and other fee deductions.
How to Read and Understand a Loan Agreement
It is better for the borrowers to read the terms and conditions of the loan agreement very well before signing it. The following are the important points to be verified
Interest Rate and Annual Percentage Rate The borrower must ensure they get the correct cost of borrowing and other charges.
Repayment Schedule Verification of the repayment schedule allows the borrowers to plan their finances as they know the EMI amount, tenure, and due date.
Hidden Fees Some lenders charge prepayment penalties, foreclosure fees, and processing fees, which must be read carefully.
Default Provisions Knowing the effect of late payments and the lender’s right in the event of default is important.
Collateral Provisions If the loan is collateralized, borrowers must look at the terms of asset ownership and recovery conditions.
Borrower Tips to Prevent Hidden Loan Fees
Comparing Loan Offers Compare loan offers from several lenders to get the lowest interest rates and fees.
Reading the Fine Print Carefully read the loan document to look for hidden fees and penalties.
Using Online Loan Calculators Loan calculators assist in calculating EMI amounts and total interest to be paid to check affordability.
Having a Good Credit Score A good credit score enhances eligibility for loans and ensures favorable loan terms.
Responsible Borrowing Borrowers should borrow only the amount required and make sure repayments are easy to manage.
Widely Used Loan Types and Their Characteristics
Knowledge about different types of loans in the financial market can assist borrowers in selecting the most suitable type of loan according to their requirements and repayment ability. Every loan type has certain terms, conditions, and eligibility. Some of the most widely used types of loans are described below
Personal Loan
A personal loan is an unsecured loan which can be utilized for different reasons, like medical emergencies, wedding, holidays, or debt consolidation. As there is no need for collateral, the lender determines the creditworthiness of the borrower and his repayment ability prior to approval.
Characteristics of Personal Loans
- No collateral is needed
- Fixed or floating interest rates
- Short to medium repayment term, usually one to five years
- Increased interest rates compared to secured loans because of the higher risk involved for lenders
Home Loan
A home loan is a secured loan that is utilized to buy, build, or repair a house. The house itself is used as collateral, so if the borrower fails to make payments, the lender can repossess it.
Characteristics of Home Loans
- Long repayment period, typically up to thirty years
- Lower interest rates than personal loans
- Needs a good credit history and stable income for the approval
- Loan-to-value ratio typically between seventy and ninety percent of the property value
Car Loan
A car loan is a secured loan used to buy a car. The vehicle itself is used as collateral until the loan is completely paid off.
Features of Car Loans
- Loan term typically falls in the three to seven years range
- Interest charged varies as per the credit history of the borrower and loan size
- Dependent upon a down payment, with lending finance covering the remaining amount
- In case of default in repayment, the lender can repossess the vehicle
Education Loan
An education loan is tailored to pay for higher studies costs, like tuition fees, boarding, and study materials.
Characteristics of Education Loans
- Moratorium period offered, i.e., repayment begins post-course completion
- Lower rate of interest, particularly for government-sponsored education loans
- Need for a co-borrower, like a parent or guardian, in the majority of situations
- Certain education loans are collateral-based, based on the amount of the loan and lending organization
Business Loan
A business loan is offered to businesspersons and entrepreneurs to finance operational costs, expansion, or working capital requirements. It may be secured or unsecured, based on the financial record and reputation of the business.
