13 Essential Loan Terms You Must Know Before Taking a Loan

Loans are a common financial tool used for various purposes, from buying a home to funding education or starting a business. However, the language of loans can be filled with jargon that may be confusing for first-time borrowers. Knowing the definitions and implications of terms like fixed rate, amortisation, and refinancing can make the loan process smoother and help avoid costly mistakes. By familiarising yourself with these terms, you can better assess your options, understand the costs involved, and make decisions that align with your financial goals.

This blog breaks down some of the most important terms related to loans that everyone should know before signing on the dotted line.

Types of Loans

1. Fixed Rate Loans

Fixed rate loans have an interest rate that remains constant throughout the duration of the loan. This means the borrower pays the same interest rate until the loan is fully paid off, providing stability and predictability in monthly payments. Fixed rate loans are ideal when interest rates are low and the borrower wants to lock in those rates for the entire term.

2. Variable or Floating Rate Loans

Variable rate loans, also known as floating rate loans, have interest rates that fluctuate based on a benchmark rate, such as the repo rate or Marginal Cost of Lending Rate (MCLR). These loans are suitable for borrowers who anticipate a decline in interest rates, as their payments could decrease over time. However, they also carry the risk of increased payments if interest rates rise.

3. Home Equity Loan

A home equity loan, also known as a Loan Against Property (LAP), allows homeowners to borrow money using their home as collateral. The loan amount depends on the value of the property and the lender's policies. Home equity loans are often used for major expenses such as home renovations or debt consolidation, offering access to significant funds at relatively low interest rates.

Loan Repayment Options

4. Amortisation

Amortisation refers to the process of repaying a loan through fixed periodic payments, typically monthly Equated Monthly Instalments (EMIs). Each EMI covers both the interest and principal amount, with the interest portion being higher at the beginning and decreasing over time. This structure provides borrowers with a clear repayment schedule, allowing for easier financial planning.

5. Prepayment

Prepayment occurs when a borrower pays off part or all of their loan before the scheduled due date. This can reduce the overall interest paid and shorten the loan term. While some loans have prepayment penalties, others, such as home loans from banks in India, do not. Prepayment is a useful strategy for those who want to reduce their debt faster and save on interest costs.

6. Moratorium

A moratorium is a temporary suspension of loan repayments, typically granted during extraordinary circumstances such as a financial crisis or natural disaster. During this period, no EMIs are required, and the borrower is not penalised for non-payment. However, interest continues to accrue, and the missed EMIs are added to the loan tenure, often increasing the total interest payable.

7. Pre-EMI Interest

Pre-EMI interest is a payment made on a loan that covers only the interest component before the full loan disbursement. This is common in home loans for properties under construction, where the borrower pays only the interest until the full loan amount is released. Once the full amount is disbursed, regular EMIs that include both interest and principal begin.

Loan Security Types

8. Mortgage

A mortgage is a secured loan where the borrower uses real estate as collateral. Commonly used for purchasing homes, mortgages allow individuals to buy property without paying the full price upfront. The borrower repays the loan over a specified period, typically 15 to 30 years, with interest. If the borrower defaults, the lender can seize and sell the property to recover the loan amount.

9. Pledge

A pledge involves using movable assets, such as stocks or jewellery, as security for a loan. The lender holds the asset until the loan is fully repaid. Unlike a mortgage, the pledged asset remains with the lender during the loan term and can be sold if the borrower defaults. Pledging is commonly seen in loans against securities.

10. Hypothecation

Hypothecation is a security interest where the borrower pledges an asset, typically movable, as collateral without transferring possession to the lender. Common examples include vehicle loans, where the car remains with the borrower but can be repossessed by the lender in case of default. Hypothecation allows the borrower to use the asset while securing the loan.

Other Key Loan Terms

11. Refinancing

Refinancing involves replacing an existing loan with a new one, usually at a lower interest rate or with different terms. Borrowers opt for refinancing to reduce their monthly payments, shorten the loan term, or switch from a variable rate to a fixed rate loan. For example, refinancing a home loan can save significant money if there’s a substantial difference between the old and new interest rates.

12. Hire Purchase

Hire purchase agreements involve buying an asset through instalments over a specified period. The buyer makes an initial payment followed by regular instalments, and ownership of the asset is transferred once all payments are completed. This option is popular for purchasing expensive items like vehicles and machinery, as it allows individuals to spread the cost over time.

13. Lease

A lease is a contract where the lessor (owner) permits the lessee (user) to use an asset for a specified period in exchange for payment. Unlike hire purchase, the lessee does not gain ownership of the asset after the lease period ends. Leases are commonly used for vehicles, equipment, and real estate, offering flexibility without the commitment of ownership.

Conclusion

Understanding these loan terms empowers borrowers to make informed decisions and choose the best loan options based on their needs and financial circumstances. Whether it's selecting between fixed or variable rates, deciding on refinancing, or understanding the implications of prepayment, being well-versed in these terms can lead to smarter financial choices. As you navigate your loan options, keep these key terms in mind to ensure that you choose a loan that fits your financial situation and long-term goals.