How Do Loans Work ?

Since most of investors today are getting saddled with loans of all kinds, it’s important for them to understand how do loans work. With increased consumerism and lifestyle changes, you have almost everyone with some kind of loan in his kitty – either a home loan, or a car loan or a personal loan among many others.

Since paying back money is your onus, it’s important to run through the basic concepts to understand how do loans work.

So, How Do Loans Work ?

You want a loan because you don’t have the money to buy something you want. If you are struggling to think what you had wanted to buy, remember that diamond necklace you shelled out for your girlfriend ?

Most of the demand for loans is for purchasing things which require a lot of money namely a home, a car or a consumer durable. Now ordinary mortals don’t have a lot  of money at their disposal. So they have to borrow money from someone else to buy their product. That someone is the lender and you, the ordinary mortal is the borrower. The lender could be a bank, a financial institution or a person you know.

Obviously, the lender isn’t going to give away free lunch – so he will ask you to pay back his money in small installments over a period of time with a small caveat. He will want a tad more than you borrowed. That’s his price of giving you free money.

In loan parlance, he is asking for interest on the money he lends you – this is the cost you bear to take the loan. So you need to pay back the borrowed money and a small extra amount with it !

One would readily agree because paying the small amount of extra money will not hurt your wallet  much and you get the flexibility of paying back the borrowed money as well as the extra  money over a period of time which becomes easy for you and most importantly, you get to buy the product you had wanted.

Generally, it is agreed between you and the lender on what frequency, eg monthly/quarterly/yearly, you will pay back the money to him.

The money borrowed is called principal, the small chunks you pay back on each frequency period over a period of time is called Equated Monthly Installment (EMI), the period is called the tenure of the loan and the cost of taking the loan is called interest on the loan.

Each time you pay an EMI, you are paying off a portion of the principal which you borrowed and a portion of the interest too – so the EMI is made up of the principal and the interest component.

Let us take an example to see how do loans work.

Suppose you want to borrow Rs 5,00,000/- for one year at 10% rate of interest. Here is how the amortization chart will look like. So the principal = Rs 5,00,000/-; the interest = 10%; the tenure = 12 months and frequency of EMI = each month.

In the example above, note that the EMI per month is Rs 43,957.94/-. In the first month the EMI consists of the principal component of Rs 39,791.28/- and interest component of Rs 4,166.67/- and in the last month, it is Rs 43,594.65/- and Rs 363.29/- respectively.

These figures leads us to a very important conclusion.

The interest you pay at the start of your loan tenure is more and this keeps on decreasing with time. The principal you pay at the start of your loan tenure is small and keeps on increasing with time. With time, the principal gets reduced as and when you pay and when it becomes zero, you have paid off your loan. This concept of paying off the loan is called loan amortization.

Also note the total interest you paid to the lender over one year in the case above is Rs 27,495.32/- : that is the lender’s earnings for lending money to you and it is the extra you pay for borrowing money to buy your favorite product. Also note how with increasing time, the principal paid keeps increasing (second last column) and the balance of the principal left to pay back (last column) keeps on decreasing till it reaches zero.

Other things to keep in mind

When you take a home loan or a car loan, the lending institution or lender will keep a right to own the product till the loan is paid off by you. This is to safeguard the lender’s money in case you do not pay him back the money you borrowed. What this means is that you have provided security for the loan you borrowed by lending your product to the lender. These are called secured loans.

However, when you use your credit card to take a loan for something you buy, it is an unsecured loan as you have provided no security to the lender.

Also note that when you take a loan for purchasing a house or a car, you cannot go and gamble away that money in Las Vegas. And that is not because everything that happens in Vegas stays in Vegas and so the world will not know you lost your shirt, it is because the lender will restrict you to purchase only that product for which you borrowed money.

However, is some type of loans like personal loans, you can go and blow it all away in Vegas. With personal loans, you can buy anything you wish.

The way loans work, if you walk over to your lender and ask for closure of the loan, you might have to pay an extra amount. This is called foreclosure of your loan. There is a facility by which you can pay a lump-sum amount towards your principal to reduce it – for some loans that will fetch a small fee as well.

Most of the loans you take will ask for a guarantor to be named. A guarantor is a person who goes under the guillotine if you decamp (probably to Vegas ?) and do not pay the principal. The guarantor will be liable to pay the loan taken in case you cannot – that’s how loans work !

Do not default on your loan. In the Western countries, a default can make your credit history look sordid. In India, repayment history on loans is already being taken into account since the last 1-2 years to check the credit worthiness of a borrower, so make sure you pay in time and do not default.