What Is Loan? Meaning, Definition, Types & How They Work

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18 OCTOBER, 2023

Today, financial flexibility is critical to realise your dreams and goals. The ability to secure finances when needed can be a game-changing advantage when purchasing a new car, seeking additional schooling, or developing a company enterprise. This is where loans come in, as they are a vital tool in personal and commercial financing.

Essentially, a loan embodies a financial agreement that acts as a safety net during financial necessity, enabling access to capital that might otherwise be inaccessible. However, loans are only sometimes suitable; they are available in diverse formats, each tailored for particular intentions and subject to unique regulations.

Now, you may wonder what types of loans are available and how they work. But before moving forward, let's understand what a loan is. So, let's get started.

What is a Loan?

A loan is a sum borrowed from a financial institution, usually a bank or financial institution, with the obligation to repay it over time. Interest is typically charged on loans, the cost of borrowing money. A loan can be used for a variety of objectives.

What are the types of Loans?

Loans serve as financial instruments to help you achieve your goals or manage unforeseen financial situations. They are of various types, each designed for a specific purpose. Here are three main categories of loans:

Based on the Security Provided

Based on the security provided, loans are further divided into two subtypes. They are:

Secured Loans

These loans require you to provide collateral. The financial institution can use the collateral to recover the debt if you can't repay it. They typically have lower interest rates.

Unsecured Loans

These loans don't need collateral. financial institutions assess your creditworthiness based on which interest rates are decided, which are higher since there's no collateral to cover defaults.

Based on the Purpose

Based on the purpose, loans are further divided into four subtypes. They are:

Education Loan

This loan funds education expenses, from undergraduate to postgraduate courses, domestic or international. You need proof of admission.

Personal Loan

The definition of a personal loan is straightforward, i.e., it is used for personal purposes. You can use this for various needs like debt consolidation, vacations, or emergencies. Approval depends on your credit history.

Vehicle Loan

You can get these loans to buy two-wheelers or four-wheelers, new or used. You might need to make a down payment, and the financial institution will own the vehicle until you repay it.

Home Loan

These loans are used to buy, build, renovate, or purchase property. The financial institution holds the property until you repay the loan.

Based on the Pledged Assets

Loans are further divided into two subtypes based on the pledged assets. They are:

Gold Loan

These loans are borrowed against pledged gold, like jewellery. The financial institution can take the gold if you cannot repay the loan.

Loan Against Assets

These loans require you to pledge assets like property, insurance policies, or investments.

How does a Loan Work?

Loans can be acquired or extended by individuals, institutions, or governments. Typically, a borrower seeking capital, whether for personal or financial purposes, approaches a commercial financial institution or a trusted acquaintance. The financial institution then provides a specified amount based on agreed-upon terms, including fees, interest rates, and the repayment structure.

For instance, if interest is paid incrementally monthly, it's called amortisation. At the same time, an interest-only loan entails paying the interest before clearing the principal balance at the end. All these terms are explicitly outlined in lending documents and contracts before any funds are disbursed.

Financial institutions may often require collateral to safeguard against borrower default, ensuring they have an asset to recover their investment if necessary. Ultimately, both parties must mutually consent to these terms before finalising the loan agreement.

Must Read : Why Pre-Closing A Personal Loan Is Crucial?

What are the Benefits of a Loan?

Taking out a loan can offer several advantages to borrowers. Some of the benefits are:

Financial Flexibility

Loans provide access to funds when needed, allowing you to cover unexpected costs or participate in chances without depleting your savings.

Structured Repayment

Loans have fixed repayment schedules, which make budgeting and managing your finances more manageable by spreading payments out over time.

Credit Building

Responsible loan repayment can improve your credit score, enhancing your financial credibility and access to future credit.

Tax Deductions

Certain types of loans, like home loans, can provide tax advantages. This could decrease your overall tax burden.

What are the Eligibility Criteria to Get a Loan?

As for the loan eligibility, these prerequisites can vary based on the particular type of loan you're interested in. However, in general, the eligibility is:

Maintaining a respectable credit score.
A consistent source of income.
You must be in
You must possess a fixed deposit, investment, or real estate if you are going for a secured loan.
A positive and established rapport with your bank.
A history of timely debt repayments.

What are the Documents Required to Apply for a Loan?

When applying for a loan, the necessary documents can vary depending on whether you're a salaried individual or self-employed. The loan required Documents include:

For Salaried Applicants

Application form with a photograph
Identity and address proof
Last six months' bank account statement
Latest salary slip
Form 16

For Self-Employed Applicants

Application form with a photograph
Identity and address proof
Last six months' bank account statement
Proof of business
Business Profile
Income tax returns (personal and company) for the previous three years
Profit/loss and balance sheets over the last three years

What are the Factors to Consider When Taking a Loan?

Several important factors should be carefully evaluated when considering a loan to ensure it meets your financial goals. These factors include:

1. Credit Score

Your credit score is vital, particularly for unsecured loans. It reflects your repayment history, helping financial institutions assess your ability to meet payment obligations.

2. Income and Employment History

Financial institutions consider your income and employment stability to gauge your repayment capacity. For self-employed applicants, a thriving business with consistent turnover is crucial.

3. Debt-to-Income Ratio

If your monthly income is Rs.1 lakh, and you already have debt commitments surpassing Rs.75,000, you might face loan rejection due to insufficient funds for expenses and repayments.

4. Collateral

Collateral value influences loan terms. Providing collateral increases financial institution confidence, potentially leading to lower interest rates, while unsecured loans usually have higher rates.

Conclusion

Loans can be powerful tools when used wisely, helping individuals achieve their goals and navigate financial challenges. However, you must have a proper understanding of how to make informed financial decisions. You should also consider the eligibility, loan fees and charges, and loan repayment cycle to avoid any debt trap.