Types of Advances / Loans / Credit or Major Ways of Borrowing and Lending
Money, is what most people believe is the basis of functioning of our society. Thought many people personally do not believe that it is hundred percent true, it would be foolish to completely do away this fact. Indeed, to an extend it does hold ground in reality. Most people spend their entire lives working for it, and yet there are only a few who are satisfied with what they have earned in the end. It is often said that no matter how much money you have, it is never enough. In fact, it obvious that this is the case in the real world because people are never happy with what they already have. Instead, they often keep chasing what is beyond their reach and then regret later when they fail to value what was pre-existing in their possession. In today’s modern economy, a person can spend not only according to how much he currently earns but also based upon how much he expects to earns in the near future. This happens using one the basic pillars of our economy i.e. loans.
But before going into details about the loans, let’s discuss the parties involved:
Who are Borrower and Lender?
Borrower: They are the people who borrow money. They are also called Debtors. They may be a single individual or an organization. There can be many reasons behind them for borrowing money.
In case of an individual it maybe for constructing a house, to start a business, for educational purposes etc. In case of organization it can be to expand their operations or to maintain their cash flow.
The borrowers borrow the money for a specific period of time, then return the money after a specified period and with a specified interest payable on the amount borrowed.
The tenure and rate of interest of the loan is specified in the loan agreement which is approved and signed by the parties, the borrower and the lender.
Now, it is highly imperative for each and every debtor to know that he or she must clearly and carefully read all the terms of agreement before putting their signature on it.
In case of any later misunderstanding, this agreement has a very important role to play. This is just like the say it at the end of all mutual fund advertisements on television that ‘please read all scheme related documents carefully.
If this not enough to make you understand, just remember that unlike Portia from William Shakespeare’s ‘Merchant of Venice’, you are least to find somehow that smart and intelligent in real life.
Lender:Lenders are individuals or financial entities that lend money to the borrower for a specified period of time and on a specified rate of interest.
Lenders earn their profits in terms of the interest earned on the amount lent. Loans are a very common part of our lives.
We all know someone who has some form of existing loan with a bank, may it be Home loan or student loan.
In case of organizations, many of the important business were started on loans and without a loan or some kind of financial aid. It becomes very difficult to start a business.
Online Lenders like halalbarqat.com offer peer to peer online loans. This means, they allow individuals to borrow and lent money among themselves without involving any form of financial institution. These type of loans are important in empowering the small businesses and are crucial in increasing employment in the country.
Loans are bitter-sweet parts of our lives. Where they pose a liability on a person, they also enable him to explore new opportunities.
Let’s get into the details about loans:
Loans and Advances
Money is the essential requirement for functioning of any household or business.
In case of households, it is required for basic amenities, maintenance and in case of business it fulfils the fund requirements in both short term and long term scenarios. But sometimes it is not possible for a person to bring in all the money by himself, so in such case he/she uses services like loans and advances.
Though most people are of the opinion that loans must be avoided at all costs due to the interest that later needs to be paid, you must realise that it is absolutely fine to take a loan at times when such is the need.
However, always make sure that if you take a loan, then you must decide beforehand on how you wish to repay it. In case of your failure, you may end up losing a major portion of your other valued property.
Loans by definition refer to, ‘An amount of money borrowed by a Person or an Entity from another Person or Entity, which is payable after a particular period of time, with an Interest charged over the borrowed fund’.
For better understanding, let’s take an example of a usual Home Loan.
A person who wants to buy a house, but doesn’t have sufficient fund to buy the house. In such a scenario, he has to approach a financial institution like a bank or any other professional money lender and creditor.
This bank offers the person a loan with predefined set of terms which tell him things like:
- How much interest he has to pay
- The amount of premium he has to pay every month
- How long he needs to pay the loan, etc.
This loan is usually backed by a security, which in most cases is the Deed (Registry) of the house. This loan is payable depending upon the plan the borrower opts for. It can be fixed time loan which is payable in full after a particular period of time along with the interest or like in this case.
Also, it can be payment plan type of loan in which the total sum payable is divided into a fixed no of instalments and the loan continues till all the installments are not paid. This is the stage when you must now clearly where you stand financially.
Only that will help you to make a clear and informed decision regarding the scheme that seems to meet your needs the most.
If you mess this up, then it gets really difficult for even your lawyer to clean the spilt milk. You must also ensure that you get all documents checked by a professional layer of expert. This does not mean that a bank will purposely try to strip you of your money but anyone can make a mistake. It is just a means of double checking for personal mental peace and satisfaction.
It is recommendable that a little bit of self-reading because it is always good to learn and you yourself are the most reliable person that you will meet ever.
Good Credit Score Helps in Easy Loan Attainment
Types of loans
Loan plans are packaged by banks, as per to the needs of their customers and thus currently there are many different loan plans available in the market. It is nothing less than a boon for all borrowers that the relevant schemes offered by the banks are designed in such a manner that they focus on different groups and needs arising in the society almost each and every day.
Loans can be of many types depending upon the payment plan, tenure and collateral requirements. Read ahead to find out about major types of loans that are offered by various banks, be it private banks or those owned by the State.
There may also be the provision for money lenders and creditors who do not function as the part of any bank but still carry out similar work and help those in need.
- Secured Loan : What do you mean by a secured loan? A secured loan, is a type of loan under which the borrower needs to leave an asset in the custody of the lender. This means that an asset such as a car or personal property or any similar item of high value is left as collateral for the loan. This then emerges as the secured debt that is owed to the creditor who extends the loan at the first place. This is basically an exchange, of collateral and the loan. However, it must be noted that if under any circumstances, the borrower fails to repay the loan, then the creditor has the legal right to take the collateral as his own. The creditor can then keep the property to himself of sell it off to earn back his loan or whatever suits him. If you look at it from the creditor’s view point, this is a kind of debt in which the creditor has certain rights over the collateral object. In fact, it is interesting to note that if the collateral item fails to amount to the value of the loan, then the creditor can file for the pending amount from the borrower.
- Unsecured Loan : Under the wide banner of finance, an unsecured loan or unsecured debt refers to any kind of debt or obligation that is not under the protection of a collateral. This is the exact opposite of a secured loan. In fact, there is nothing upon which the creditor can be guaranteed to get back the loan that he is extending to the borrower in need. Now, you must be wondering that what is the creditor left with if the one seeking the loan fails to return the money. Well, in case of the borrowers bankruptcy, the creditors have the power to file for a claim on the assets of the borrower. This is generally done after the secured creditors, if any, have recovered their portion fair and square. The biggest disadvantage for creditors in this type on loan or debt is that they often get back only a small portion of their claims, unlike the secured creditors. This is why most creditors do not wish to engage in such a deal or transaction.
- Non-fund Based Loans :Non-fund based loans are loans in which the bank does not make any funds outlay, instead it only gives assurances. Examples of non-funding loans include Letter of Credit and Bank Assurances. The non-funding loan can be converted to a fund-based advance if the terms of contract between the client and the counter-party are violated by the client. Non-funding loans are also called Contingent Liability of the banks.You may recognize the term ‘Letter of Credit’ from the recent PNB fraud case. They are, in simple terms, a letter through which the issuer bank vouches for the holder of the letter, so that the holder can take credit from a third party (Bank or any other financial Entity). Non-fund based loans are mostly secured loans.
- Fund Based Loans : The Fund based loans are loans in which direct cash is provided to the debtor. This type of loans mostly fall in the Secured Loan category.
- Term Loans :Term loans are loans provided by banks for a particular period of time. Most Term Loans are provided by Commercial Banks. They provide loans for Short, Medium and Long term.Short term loans are loans whose tenure is less than one year. Medium term loans are loans whose tenure lasts between 1 to 3 years. Long term loans are loans whose tenure is above 3 years. Although in case of agriculture loans, the tenure in different types of loans changes. Short term loans with tenure less than 15 months. Medium term loans with tenure between 15 months to 5 years and Long terms loans with tenure of more than 5 years.
- Demand Loans :A demand loan is an uncommon kind of loan that is eligible to be summoned for complete repayment without any prior or early warning to the one who is borrowing the money or taking the loan from the creditor. Thus, it means that the repayment from the borrower’s end depends on the demand of the lender or creditor. This is not like a common loan. A general loan can be repaid in instalments and comes with a fixed maturity date. But, this is not the case with a demand loan. Usually, demand loans are created between a pair of two business partners who have been in the trade since long. There is a higher element of personal bias. This is usually done with the assumption that the borrower will surely pay back the borrowed amount on his own, within a reasonable period of time. Due to this unsaid trust, no specific terms are discussed. However, if the relations go sour over a period of time, the lender can immediately ask back for the entire sum. Often, it is seen that demand loans are taken in case of new business ventures. In such a given scenario, it gets quite obvious that the money will be recovered only after substantial profits have been made by the company or the borrower. The borrower may return small amounts as and when he wishes to but in other situations, the full amount has to be returned when the lender demands for it. From the viewpoint of a lender, a demand loan is great. This is so because the longer it takes to be returned, the more interest can be charged. However, remember that if the lender himself is in need or suspects that the borrower will not be able to return his money, then he can demand it anytime, as per his choice.
- Personal Loans :If the debtor is an individual person (consumer) or a business; it is called personal loan or consumer loan. Common examples of personal loans include mortgage, car and educational loan, credit card etc. The major criteria for a bank to provide Personal loan to a consumer is his/her credit score/rating. For example, CIBIL score. The credit score of debtor defines his credit worthiness, i.e. how likely is this debtor to follow through on his debt liabilities.
- Commercial Loans :Commercial Loans are similar to personal loans, but instead of giving credit to an individual consumer, the loan is provided to a commercial organization. Subsequently, the credit score of the entire organization is taken in consideration while providing personal loans.
- Working Capital Finance :These types of Loans are provided to Businesses in order to help them meet their capital requirements. The money borrowed from the bank in such cases is put into operational functions of the business and are utilized in creation of current asset. Before providing the loan the lending banks carries out a detailed analysis of the borrower’s cash requirements. These types of loans are mostly Secured Loans.
- Project Finance :The main focus of these types of loans is to provide medium to long term loans in Indian or foreign currencies to industrial and manufacturing projects. Well, an interesting point to be noted here itself is the fact that dollar is the world’s strongest currency. In fact, you would be shocked to know it accounts for more than fifty percent of the foreign reserves in all central banks of the world combined. Now, that’s the power of the United States of America. Thus, dollar is also one of the most sought after currencies in the world due to its strong economic hold over the world financial front. The best examples of project finance loans would undoubtedly include term loans and debentures to name a few. There are definitely numerous other options as well.
Advances on other hand are:
A source of finance which can be provided by the bank or any other financial entity, to the debtor so that he/she can meet his financial requirements in the short term. They are a credit facility which should be repaid within one year from the day they were issued, as per norms issued by US Fed Reserve in USA and in third world countries like the Reserve Bank of India for lending and also according to the terms issued by the lending banks.
Types of Advances:
- Short Term Loans: They are the Advance in which the entire amount is provided to the debtor at one time.
- Overdraft: They are facility provided by the bank in which the customer can overdraw money from his account up to a specified limit.
- Cash Credit:> They are the facility granted by the bank in which the customer can borrow money up to a certain limit against the pledged asset.
- Bills Purchased: They are the advance facility provided by the bank against the security of bills.
Where does the loan risk lie?
You must have surely come across many people who engage in conversations about the potential risks in loan. But, the main question arises when you try to point the exact area of risk and difficulty. This means that the main points of conflict need to identified so that they can be worked on and curative measures can be adopted as and when the need arises.
Also, this is very important to know so that you are able to decide if you are at all ready to take a loan to pay for your expenses.
This question has a two part answer:
First, we need to understand the potential of monetary loss to the debtor or the borrower.
Second, the risk potential also needs to be understood and examined thoroughly from the view point of the bank or the one who is lending out the sum.
Both these perspectives make a lot of difference to you since you can be on either sides of the fence at any given point of time.
Borrower and Debtor:
The average person who takes a loan from the bank in order to buy a house or pay for his kids education or to buy any other amenities, may face the following problems’:
- In case of instalment based Home Loans, the debtor usually ends up having to pay up for the loan for a time period anywhere between ten to fifteen years. In such cases, the borrower has to constantly make sure that sufficient cash is available in his account, so that an instalment is not missed. Because even if a single instalment is missed, it affects the credit score of the person. But a period of ten to fifteen years is a very long time and thus it brings with it a level of uncertainty.
- People who have missed a few installments on their previous loans, end up having to pay more interest on any of their future loans because they are deemed as ‘Likely to default’ by the bank.
- In case of mortgages or other type of secured loans, the borrowers who are unable to pay their installments are at a risk of foreclosure
- In case of mortgages issued from a private bank, the debtors are at a risk of higher interest rates in case the Non-performing assets of the bank have grown significantly for that particular quarter. Non-performing assets are the loans given out by the bank, which are in default, or whose installments are not being paid. In case of a private bank, there are no government grants available to account for the losses. Therefore, when there is a significant growth in the Non-performing assets of the bank for a particular quarter, the bank has to take drastic measures in order to maintain its cash reserves. And if the borrower is unable to accommodate this new interest rates and he is unable to pay his installments in full, he is again in the risk of foreclosure.
Lenders and Banks:
Giving out loans is one the main businesses of a bank. This may sound like a loss to you, but it is actually one of the top means of earning for banks. That is precisely why you are constantly faced with advertisements on loans all around.
The installments paid by the customers are how the banks fund their day to day operations. But the problem arises when the instalments are not paid.
Commercial banks issue loans to thousands of people, possibly even hundreds of thousands, in case of major commercial banks like HDFC or ICICI.
Now majority of these loans are security backed loans but still if the instalments stop, it costs the bank both money and time in order to get what its owed from the borrowers.
Following are the major issues face by the banks:
- In case of a single loan, the bank marginalizes its loan by taking an asset as collateral. These assets may include Fixed Deposits, property deeds etc. But in case the loan defaults, the bank has to spend its own money on foreclosing the mentioned assets. This also takes a lot of time and for this time period, the earning which would have been made from this loan, are marked as a loss in the ledgers. And even if the banks foreclose the property, there is no guarantee to when and if they will be able to recover the full amount they are owed along with the interest.
- Most banks are fall under the public sector. This means that commercial banks like Citi, HSBC, Bank of China, China Construction Bank, Industrial and Commercial Bank of China, Barclays, The Saudi British Bank, Riyad Bank, Bank of Qatar and Oman, HDFC, ICICI, etc. have people money invested in them, in the form of stocks. Therefore, any change in the market sentiment towards the banks reflects upon their value in the market. Take ICICI bank for an example, in the wake of CEO Chanda Kochhar scandal, the stock prices have plummeted. Also as the banks are public, they are obligated, according to SEBI norms, to maintain a certain level of transparency with their customers and stockholders. This means that the public is aware of the quarterly gains and loss of the banks. In case of losses, it reflects badly upon the performance history of the bank and thus the stock prices plummet again. This means that the banks not only have face loss on their books, but they also have to deal with the loss in the market value.
- Major lenders like ICICI and HDFC, carry a huge risk with them, as they have provided loans to hundreds of thousands of people. And if a situation arises, like the 2008 recession, and a large portion of these borrowers default on their loans simultaneously, the bank books a huge loss in a single day. This leads to increases interest rates, which in turn leads to more defaults. This domino effect is capable of bankrupt a bank. Plus every commercial bank have to follow a set of internationally defined banking norms, called the BASAL norms. These norms dictate the bank to have a minimum amount of liquid cash reserve, which is proportional to the money it needs to fulfil all its customers’ demands.
Why should one care about borrowing and lending?
Now the big question is why should the normal folk, with no loan and with no relation to the banking industry care?
The answer is simple. We should care because banking affects all of us, even if we realize it or not. The healthy working of the banking system is very important for everyone.
For better understanding, let’s take an example:
There is a man call Ajay. He works in IT industry. He is a fresher at the beginning of his career and thus has no loans. He makes 25k a month, which for him, being a bachelor, is more than enough.
He spends ten thousand on rent, two thousand on commute and ten thousand on food and other amenities.
Now as he is in no way connected to the banking industry, there should be no effect of Ajay’s life if the banking sector plummets. Or should it?
Let’s take a look:
- If the bank, from which his flat owner borrowed the money, faces loss, then this bank will increase its interest rate, which in turn would increase the premium payable at the end of the month. Now this flat owner may also be in the service industry, this means he also work on a fixed budget. If the premium amount rises, and if he finds the increased premium is unaffordable, he may either sell the flat or he may be forced to increase the rent. In any case, poor Ajay will either be homeless or will have to spent money, which he would have spent on food and amenities, on his rent.
- If the whole banking sector is in a downward spiral, all the investors in the bank also face a loss. As in India, Government has vested interest in many commercial banks, call Public Sector Banks, the plummeting of the banking industry will result in the Government of India incurring losses. The Government as you know, funds its daily operations from various kinds of taxes. Now as our Government is cash rich, it can incur losses for quite some time, but if the losses continue, then the Government will increase the taxes in order to counter the losses it is incurring in the banking sector. This mean Ajay, now will have to pay more basic stuff like food, petrol etc.
- It is a common knowledge that when employee receives his salary from a company, money is deducted from his pay in the form of income tax, PF, gratuity etc. Now as the banking industry is failing, the cost of maintaining the employee’s provident fund account will increase, which in turn would mean increase in PF premium, which mean that now Ajay, instead of getting 25k a month, would only get 23-24k a month.
- As most commercial banks also offer insurance plans through their subsidiaries, if the banking sector fails these subsidiaries, as they fall under the same organizational umbrellas will also face loss. In order to cope with the loss, and in order to maintain their fluid cash ratio (remember BASIL norms), these insurance providers will increase their premiums. Increased premium means that the company Ajay works for, who took a Medi-claim and a group insurance policy for each of their employee, will now have to pay more money to the insurance provider for their possibly thousands of employees. This means that this IT firm will book a huge loss in a single day. In order to cope with this loss, either the company will increase the insurance charges being cut from their employee’s salary or they may even lay off some people. Which in turn means that our poor Ajay, will either end up getting less pay or, in worst case, he may end up unemployed.Now we know the ways in which the life of a person, with no connection to the banking industry, is affected by the plummeting of the banking industry. Now you may think that all this is too farfetched and you don’t remember anything like this happening ever. Well, in that case you will be wrong and all these things discussed above are not that farfetched.During the Great depression, banking industry plummeted due to stock market crash. But it didn’t end there. People didn’t have enough money to put food on their tables, stock their shelves or even to keep a roof over their heads. USA, one of the richest countries to have ever existed in the history, had bread lines all over the country for almost a decade.Almost a decade ago, our generation too faced almost similar circumstances. During the housing market crash of the 2007-2008, around 9 million jobs were lost in USA alone. It was the biggest recession to ever exist since 1930’s.
Now again you may think that all these examples are USA related and such a thing could never happen in India ever as the banking structure in India is completely different of the one in USA. Well, I agree that banking structure in India is completely different from the one in USA but it doesn’t mean such an event is not possible in India. The current NPA in India gross around 127 Billion dollars. This means that there is 127 billion dollars’ worth of bad loans in the country.
And secondly, India was indeed affected by the events mentioned above. Though, India economy was not based mortgage based securities, it was based on trade. Collapse of US stock markets in 2008 led to collapse of trade between the two countries. India is one of the major exporters of services and goods and manpower to US. Lack of liquid cash in the US led to decreased demands and thus it adversely affected the trade. Indian Government incurred major loses which in turn led to a recession of its own in the country. And all this started with loans
What can we do regarding loans?
As the consumer, all we can do is think smartly when taking loans. This means that, only that amount should be borrowed, whose premium the borrower can pay, adjusting for inflation and speculated gain interest rates.
To be on the safer side, the borrower must make sure that he only borrows that amount of money, whose interest he can pay even it is increased by up to 2.
What can banks do regarding loaning?
The banks whose business model relies on the giving loans out to the customers, should employ proper risk management techniques.
Diversification of assets also helps in minimizing the risk held by the banks. This mean investing in non-dependent sectors, the sectors which are not affect by gain or loss in other sectors. This way the losses incurred from one sector can be normalized by the gains from the other.
What can the governments do regarding loaning?
The Government can implement a much strict set of norms than the one’s present now, directing how the banks should operate so that customer’s financial safety is of the highest priority.
- They can make sure that money lenders and insurance providers do not fall under the same umbrella as that is a disaster waiting to happen.
- Government can make sure that NPA’s are properly managed, especially in the Public Sector Banks.
- Prosecute the corrupt Public Sector Bank staffers responsible for the NPAs without covertly aligning with them.
- At best, privatize the Public Sector banks in third world countries like India.
Credit has the ability to build a modern economy but lack of credit has the power to destroy it, swiftly and absolutely.
This saying holds true in more ways than we can imagine. All the financial crisis of the past mentioned above and the one’s speculated to happen, all start due to a variety of factors but they hurt the common people in terms of loans. Our entire banking model is based on the Lending and borrowing. Hence, one not emphasize enough, the importance of Loans in our society.
After this thorough study regarding all aspects of borrowing and lending we will naturally be able to:
Make best use of loan interest calculator, loan EMI calculator and loan app
Make preparation for loan apply or application
Understand Working Capital Loan
Prepare presentation for Vehicle Loan
Thus, from the above understanding we shall now also be able to handle our finances easily and properly, and not remain ignorant.