The Most Authentic Guide on Personal Finance and Investments


Words of Wisdom : "Be careful about reading health books. Some fine day you’ll die of a misprint." ~ Markus Herz

Key Financial Terms That You Must Know (Part 1 - Loans)

As I have often stated, managing money is really (really) SIMPLE. So much so that even a school kid can master it.

I guarantee that you will find it lot easier than trigonometry and calculus; chemical reactions and equations; Newton’s and Einstein’s laws; etc. that you studied in school.

Just remember one thing... financial jargon has been created just to confuse you, scare you and ultimately enslave you. Because, that's how the financial service providers and their agents can make TONS of money... at your expense.

So, to empower you against misguidance, misinformation and misselling, commonly used financial terms — in loan financing — are explained in plain and simple terms.

1. Secured Loan
When the bank’s loan is protected by an asset mortgaged in its name, it is known as secured loan.

Suppose you fail to repay your car loan (or home loan). Then, the bank has the right to take possession of your car (or the house) and sell it to recover its money.

As you will note, when loans are backed by an asset, the bank’s risk is considerably reduced. Hence, secured loans are available at much lower interest rates.

Keep this in mind whenever you plan to borrow money. If you can give any asset as a security, you can save a lot on the interest cost.

2. Unsecured Loan
You don’t mortgage any asset against a personal loan or credit card. In the absence of any security, these become the unsecured loans.

Hence, to recover its loan, the bank is solely dependent on your ability to pay. If you default, it has no recourse (except taking legal action, which is cumbersome process).

Given this higher risk, loans without any collateral or security, are priced much higher.

Hence, unless totally unavoidable, don’t go for unsecured loans. It’s not good for your financial health.

3. Zero Percent Loan
The latest LED TV you wish to buy costs Rs.36,000. Instead of the entire amount upfront, the dealer asks you to pay Rs.3000 per month over the next 12 months.

So, you get a loan of Rs.36,000 and you have to repay Rs.36,000 only. You don't have to pay anything extra for this 12-months credit. In other words, it’s a zero percent loan.

Well, frankly speaking, no one will give you money for free. After all, they are running a business, not a charity organization.

So please understand that, in such so-called alluring offers, the interest cost is already built into the cost of the gadget. Or it will be recovered from you in some different form (e.g. processing fees, administrative charges, etc.)

loan-financing-jargon
Has the financial mumbo jumbo left you puzzled and clueless?

4. Loan to Value (LTV) Ratio
If the property costs say Rs.80 lakhs, bank is not going to lend you the entire Rs.80 lakhs. It will ask you to pay a part of the cost.

Normally, banks will finance only around 70-80% of the cost. This — Loan Amount / Asset Value — is known as Loan to Value ratio

So, to buy the above property, bank will provide only Rs.56-64 lakhs. You will have to contribute the balance 20-30% i.e. Rs.16-24 lakhs (this balance amount payable by you is also known as the margin).

To the extent your pocket permits, go for minimum LTV Ratio or the maximum margin (because more margin = lower loan amount = lower interest burden). Most people mistakenly do the opposite.

5. MCLR
Marginal Cost Lending Rate (MCLR) is the benchmark used by banks to fix the interest rate on your loans. (It was introduced w.e.f. April 2016, replacing the earlier Base Rate formula).

Each bank has to announce its MCLR every month, based on its cost of funds. (There is not one but many MCLRs, based on different maturities – one-month, three-month, six-month, one-year, etc.) 

So typically your home loan floating interest rate will be = One-year or Six-month MCLR + a ‘Spread’.

And, after every one year or six months as the case may be, the new MCLR prevailing at that time will apply on your outstanding loan balance.

Important: For most banks, their Base Rate is much higher than the present MCLR. So, the existing home loan borrowers must explore the option of switching from Base Rate to MCLR (if the cost of switching is not too high).

6. EMI
EMI or the Equated Monthly Instalment is the amount that you have to pay every month, till the end of loan tenure.

For the ease of payment, the loan amount and the total interest payable over the period of loan, is converted into a fixed amount to be paid every month… hence the financial term ‘equated monthly instalment’.

Each EMI consists of two parts — interest and principal. 

At the beginning of the loan, the full amount is outstanding. So the interest part of the EMI is much higher as compared to the principal. As the loan gets repaid every month, the outstanding loan balance reduces. Accordingly, at the end of the tenure, the interest portion of the EMI is very small and major part is the principal.

7. Pre-EMI and Pre-payment
Pre-EMI is particularly applicable to property, where the construction takes 2 to 3 years. And, you have to make payments to the builder, based on the construction schedule.

So, after you have paid your contribution or margin to the builder, the bank disburses the loan to the builder in instalments as the construction progresses.

Since the loan is only partially disbursed, you are liable to pay only the applicable interest to the bank on the disbursed amount. This is called pre-EMI payment or pre-EMI interest.

Your normal EMI — which includes both interest and principal — starts only after the loan is fully disbursed.

Pre-payment is different from pre-EMI. It is the loan amount repaid ahead of the schedule — i.e. over and above the normal monthly EMIsPre-payments help you to clear your debt much in advance compared to the initial tenure.

This, in brief, are some of the commonly used key terms in loan financing.

If any other financial mumbo jumbo has left you stumped, don’t hesitate to shoot an email to me at contact@wealtharchitects.in.

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