It has been repeatedly seen that aspirational borrowers generally apply for personal loans, gold loans, home loans, credit cards, and other similar credit lines without understanding the intricacies and complications associated with borrowing.
While applying for all such credit instruments, it is important to clearly understand the agreements, key terms, and conditions related to the borrowing transaction. This is important so as to avoid surprises later and face unwanted situations.
The psychology behind loan terms often results in borrowers focusing on simple numbers, such as interest rates, overlooking important conditions that influence the total cost of repayment.
Here are ten essential loan terms borrowers should understand, acknowledge, and know clearly before going ahead with any particular loan:
1. Principal
This is the original amount of money, i.e., the funds borrowed from the lending institution, excluding interest. This forms the base on which interest is calculated and decreases as repayments are made.
2. Interest rate
This is the percentage charged on the principal by the lending institution for borrowing money. It can be fixed, i.e., unchanging in nature, or floating, i.e., variable based on market rates. This is the single most decisive factor in determining the loan product and how lucrative it is for any particular borrower.
3. EMI
The EMI (Equated Monthly Instalment) represents the fixed monthly payment made by the borrower that includes both principal and interest. This particular payment is efficiently structured across the entire loan tenure to complete the repayment properly and in a convenient manner for the borrower.
4. Loan tenure
The loan tenure is the entire duration agreed upon by the lender and borrower for completing the repayment of the loan. Longer tenures reduce monthly EMIs while increasing the total interest paid. On the other hand, shorter tenures increase monthly EMIs, reducing the total interest paid.
5. APR
This figure represents the comprehensive cost of borrowing expressed annually. It includes interest and all fees cumulatively. APR (Annual Percentage Rate) gives a more comprehensive and clearer picture of the actual loan cost than just the applicable interest rate. This figure is generally checked by professionals before proceeding with any particular borrowing product, such as a credit card or a loan.
6. Prepayment
Prepayment is an option provided by the lender where the borrower can pay back the loan or part of it before the due date. Such a payment can go a long way toward reducing interest liability and reducing the overall stress related to any loan. Still, it is crucial to keep in mind that some loans may have penalties for early repayment. The complete details on prepayment must be clearly understood by borrowers before going ahead with any loan.
7. Processing fees
Processing fees are the charges imposed by the lender for administrative work related to the entire process of approving the loan. This is important for the bank or the lending institution to run properly and holistically. Processing charges can be deducted upfront or added to the loan amount. As a sensible borrower, one should always inquire and understand the processing charges that will apply to the loans secured by them. Any loan product should only be selected after careful comparison and professional guidance.
8. Moratorium
A moratorium is a temporary pause in loan repayments allowed under special circumstances. For example, there were moratorium periods during the peak of the COVID-19 pandemic. These were provided to ease the burden of repayment on borrowers when the entire economic activity was temporarily stalled. It is crucial to factor in that interest may still accrue during the moratorium period.
9. Collateral
An asset pledged to the lending institution as security for the loan. This is nothing but a guarantee in case the borrower defaults. A collateral can be a property, gold, a fixed deposit, etc. The lending institution in such cases can liquidate the asset to recover dues in case the borrower fails to repay.
10. Loan-to-value ratio
The loan-to-value ratio represents the loan amount to the value of the asset securing the loan. It determines how much a borrower is willing to lend against the property value. A lower LTV (Loan-to-value) ratio indicates lower lending risk. Lending institutions use to decide loan eligibility, repayment terms, and applicable interest rates.
In conclusion, personal loans come with risks such as high interest rates, debt trap risks, hidden charges, and impact on credit score, fixed repayment obligation, and the possibility of legal consequences if the loan is not repaid properly. All these factors must be considered holistically before applying for a personal loan.
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