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What is a loan and how does it actually work?

Remember the time when you wanted to go to the movie with your buddies but didn’t have enough cash.

You basically had two options – either ask your parents for some extra allowance or request your friends to lend you some cash with a promise to repay them as soon as possible.

No matter which option you chose, this would have been your first experience of what the financial world calls – A loan.

Officially, banks and other financial institutions are the ones who can lend money. They offer loans to anyone they find reliable enough to pay it back on time whether it’s people, companies, businesses, or even organizations.

What is the benefit for the lender? The lender gives the loan with the expectation of getting an additional amount known as interest.

Let’s understand with an example –

Say you take a loan of Rs. 50,000 for three years with an annual interest rate of 4% from a bank.

You have to pay back Rs. 53,143 instead of Rs. 50,000 that you borrowed.

Here, the additional Rs. 3,143 paid back to the bank is the interest paid by the borrower for the loan.

A loan is an act of lending someone something tangible. In basic terms, you can lend anyone practically anything – an adored book, a much-loved game, a favourite t-shirt, etc.

But in the world of finance, giving a loan is lending money for a specific period with an expectation of getting it back. The entire crux of a loan is dependent on the promise of returning the money that was taken.

Can ‘anyone’ apply for a loan?

Yes; anyone above the age of 18 can apply for a loan. But it’s up to the financial institution to decide whether to approve that application.

You see, the bank or financial institution cannot just give you the money they have. They need to know if they can rely on you to pay back the loan along with interest.

What do banks check before lending you the money?

If you are looking to take a loan, here are the questions you need to ask yourself:

  • How much money do you need?
  • How long will it take for you to pay it back?
  • How much will you pay as interest?
  • Can you stick to the payment cycle?
  • Does the personal loan have additional fees?
  • Do you have a good credit score?
  • How soon do you need the money?

Following are a few things you need to check before applying for the loan

  • Do not borrow more than you can repay
  • Do not take a loan to treat yourself with expensive items
  • Do not keep it a secret. Inform your family about the loan
  • Ensure that the interest rates are low
  • Make a plan on how to repay the loan
  • Get quotes from multiple lenders and pick the one that best suits you
  • Ensure the timeline and repayment schedule suits you well
  • Don’t forget to look into the drawbacks of getting a loan

But is it wise to take a loan?

Applying for a loan should be a well-thought-through decision. Ask the following questions before when opting for a loan:

  • What is the interest rate and can you afford to repay at this interest rate?
  • What are the fees and penalties?
  • Do you need to offer a collateral as security against the loan?
  • Do you already have loans? If so, how many?

So, no matter how many times you may receive the call from a loan agency stating – “Congratulations. You have a pre-approved loan of….” availing that loan and paying it back with interest is no walk in the park.

But how does the lender measure creditworthiness?

Do you remember when you and your buddies decided to skip cricket practice and watch Fantastic Beasts: The Secrets of Dumbledore on the day it was released? Two of your friends did not have ready cash for the ticket and asked others to pay for them.

Based on your past experience you know that one of them always pays you back while the other talks about paying it back but never does.

So, whom are you more likely to offer willingly?

Of course, it’s the one who tends to pay you back.

Similarly, lenders need to know who has a good track record, i.e. who has historically paid back the amount on time.

And how do they know that?

By checking the Credit Score.

What is a credit score, and how is it affected by a loan?

A credit score is like a background check. The credit score is given by a credit bureau after they assess your ability to repay a loan.

It gives an indication to the lender of how likely you are to repay the loan or whether you may default on the loan.

The bureaus do this by checking whether you have been regular or not with repaying your loans in the past.

So, you must be wondering how you, as a teenager can build your credit score?

Here’s what you can do with your parent’s help -

  1. Learn about credit cards and how they work
  2. Test the waters with add-on credit cards jointly with your parents

Now that you have built a good credit score, how can you maintain it?

Well, here’s how:

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However, if you are taking a loan for the first time, this information will not be available.

Then the lending institution will check other essential factors such as your income stability, assets and so on.

Knowing how a loan works before you need one makes it easier when you actually require a loan.

While today it is easy and convenient to take a loan, the smarter thing to do would be to have complete clarity about why you want the loan in the first place.

You are still young and just stepping into the real world. Right now, the world is your oyster, and it’s your job to find the pearls. But finding these pearls can be very expensive.

So, why not be prepared? Because as the saying goes, to be prepared is half the victory.