Loans in the Banking Sector

Loans in the banking sector play a crucial role in the financial world. They are a vital concept for banking and finance aspirants, as well as for practical purposes. Let’s begin by understanding what a loan is.

What is a Loan?

• A loan is a predetermined amount of money borrowed from one party (the lender) by another party (the borrower).
• The borrower agrees to repay the loan amount, along with interest and other charges, in the future.
• Loans come into play when one source requests a specific sum of money from another source for a fixed time period.
• When the borrower knows the exact amount of financing required, they can borrow a specific amount for their project or purchase, as per their needs.
• A key feature of a loan is its predictability.
• In essence, a loan is a type of debt facilitated by an organization to another organization, with a specific interest rate.

Advantages of Loans

Loans offer several advantages to borrowers, including:

• Access to Funds: Loans provide individuals and businesses with access to funds that they may not have otherwise.
• Flexibility: Loans offer flexibility in terms of repayment options and loan terms.
• Tax Benefits: Interest paid on certain types of loans, such as home loans and education loans, may be eligible for tax deductions.
• Building Credit: Repaying loans on time helps build a positive credit history, which is essential for obtaining future loans.

Disadvantages of Loans

While loans offer advantages, there are also some disadvantages to consider:

• Debt: Loans create debt, which can be a burden if not managed properly.
• Interest Payments: Borrowers must pay interest on the loan amount, which increases the overall cost of borrowing.
• Collateral: Some loans require collateral, which is an asset that the borrower pledges as security for the loan. If the borrower fails to repay the loan, the lender may seize the collateral.
• Default: Failure to repay a loan can lead to default, which can have serious consequences, such as damage to credit score, legal action, and difficulty obtaining future loans.

Loans in the banking sector are a vital financial tool that can provide individuals and businesses with access to funds for various purposes. However, it is important to understand the different types of loans, their advantages, and disadvantages before taking on any debt. By carefully considering these factors, borrowers can make informed decisions and use loans effectively to meet their financial goals.

Types of Loans

Based on their availability, various types of loans are offered by public and private sector banks in India. Here are five main categories of loans:

1. Secured Loans:

• Loans against fixed deposits: Borrow against your fixed deposits.
• Home loans: Loans to purchase or construct a residential property.
• Gold loans: Loans against gold jewelry or ornaments.
• Loans against property: Loans against commercial or residential property.

2. Unsecured Loans:

• Personal loans: Loans for various personal expenses without collateral.
• Short-term business loans: Loans for working capital or business expansion.
• Vehicle loans: Loans to purchase vehicles for personal or commercial use.
• Education loans: Loans to finance higher education expenses.

3. Demand Loans:

• Loans that can be recalled by the lender at any time without prior notice.

4. Subsidized Loans:

• Loans offered at a lower interest rate to specific categories of borrowers, such as farmers or students.

5. Concessional Loans:

• Loans offered at a lower interest rate to promote specific sectors or activities, such as agriculture or small businesses.

Other Types of Loans:

• Term loans: Loans with a fixed repayment period and interest rate.
• Bank overdraft facility: Allows customers to withdraw more money than their account balance, up to a specified limit.
• Letter of credit: A document issued by a bank guaranteeing payment to a seller on behalf of a buyer.
• Bank guarantee: A guarantee issued by a bank to a third party on behalf of a customer.
• Lease finance: Financing the acquisition of assets through lease payments.
• SME collateral-free loan: Loans to small and medium enterprises without collateral.
• Construction equipment loan: Loans to purchase construction equipment.
• SME credit card: Credit cards designed for small and medium enterprises.

Explore more details about the Bank PO Exam and various types of loans.

Secured Loans

• Secured loans are typically used to purchase property.
• If the borrower defaults on the loan, the lender can sell the collateral to recover the debt.
• Secured loans offer lower interest rates and higher borrowing limits compared to unsecured loans.
• In some cases, the interest paid on secured loans may be tax deductible.

Types of Secured Loans

Home Loan

• A home loan is a secured loan used to build or purchase a new home.
• The interest rate on a home loan is based on the borrower’s credit score.
• Home loans typically have a term of 20 to 30 years.

Loan Against Property (LAP)

• A loan against property (LAP) is a secured loan in which the borrower pledges residential, commercial, or industrial property as collateral.
• The loan amount is typically a percentage of the property’s value.

Gold Loan

• A gold loan is a secured loan in which the borrower pledges gold jewelry or coins as collateral.
• The loan amount is typically a percentage of the gold’s value.
• Gold loans are typically used for short-term needs.

Loans Against Fixed Deposit

• A loan against a fixed deposit (FD) is a secured loan in which the borrower pledges a fixed deposit as collateral.
• The loan amount is typically a percentage of the FD’s value.
• The loan term cannot exceed the term of the fixed deposit.

Unsecured Loans

• Unsecured loans are not backed by any collateral.
• Unsecured loans can be obtained from private lenders, banks, and other financial institutions.
• The interest rate on unsecured loans is typically higher than the interest rate on secured loans.
• Unsecured loans carry more risk for the lender, as the borrower may not repay the loan.
• Unsecured lenders are not the priority to be paid in the event of bankruptcy.

Types of Unsecured Loans

Personal Loans

• Customers with a stable income and good credit score can avail this loan at a competitive interest rate.
• Many people use personal loans for family wedding expenses, vacations, home renovations, kids’ higher education, etc.

Short Term Business Loans

• Short term business loans are used for small enterprises or startups.
• It is an unsecured loan availed by individuals and organizations to fulfill daily business expenses.
• Expenses can include small business loans for MSMEs, machinery loans, equipment finance, loans for traders, loans for women entrepreneurs, etc.

Education Loans

• Education loans are usually applied for higher education and are common among students.
• Education loans include basic course fees and other expenses like hostel fees, exam fees, etc.
• The student is the primary borrower, and their parents, siblings, spouse, etc., are guarantors or co-applicants.
• Education loans can be for part-time, full-time, or vocational courses, in addition to graduation and/or post-graduation courses in different fields such as medicine, management, engineering, etc.

Vehicle Loans

• Vehicle loans are unsecured loans for buying different types of vehicles, either new or used.
• Before granting a vehicle loan, banks check the customers’ credit score.
• Other factors considered include the loan’s duration and the applicant’s history.

Demand Loan

• Demand loans are short term loans with no fixed duration for repayment.
• Demand loans can be repaid at any point in time.
• Demand loans comprise floating rate of interest that can change as per monetary policy.
• Demand loans can be secured or unsecured.

Subsidized Loan

• The interest rate is reduced by the subsidy.
• It is usually provided to students for education-related expenses.
• In a few cases, the whole amount of interest in the subsidized loan is paid by the government.

Concessional Loan

• Concessional loans are granted through below-market interest rates, grace durations, or a combination of both.
• They are also known as soft loans.
• Concessional loans are provided by developed countries to developing countries.

Loans in Banking Sector – Types of Loans

Term Loan

• Term loan is a loan specifically provided for business requirements that need to be repaid within a specified time period.
• It has a fixed interest rate with a monthly or quarterly repayment schedule and a set maturity date.
• Term loans can be secured or unsecured, with secured loans having lower interest rates.
• Term loans are classified into three types:
  • Short-term loan: Repayment duration less than 1 year
  • Medium-term loan: Repayment duration between 1 to 3 years
  • Long-term loan: Repayment duration above 3 years

Bank Overdraft Facility

• A bank overdraft facility allows businesses to withdraw funds greater than the available amount in their current bank account.
• The amount withdrawn and the interest to be paid on overdrafts are usually decided before the sanction.
• The bank overdraft facility is considered a source of short-term funding as it can be covered with the next deposit.

Letter of Credit

• A letter of credit is a document provided by a financial institution assuring payment to a seller upon presentation of certain documents to the bank.
• It guarantees payment as long as the services are ongoing and acts as a guarantee to the seller that they will be paid as per the terms and conditions.
• Letters of credit are commonly used in trade financing when goods are sold to customers in foreign countries or when trading parties are unfamiliar with each other.

Lease Finance

• Lease finance is a financing mechanism that allows companies or individuals to own and use specific assets for medium or long-term durations in return for payments.
• The lessor (finance institution) purchases the assets and becomes its legal owner.
• The lessee has the option to gain ownership of the identified asset by providing the final rental or installment or by negotiating a final purchase amount with the lessor.

SME Collateral-free Loan

• SME collateral-free loans are business loans provided to small and medium enterprises (SMEs) without the requirement of collateral or third-party assurance.
• These loans are available to both startup entrepreneurs and existing SMEs.

SME Collateral-Free Loan

• SME collateral-free loans can be used for various purposes, including working capital needs, expansion plans, and the purchase of machinery.
• Learn more about risk management in the banking sector here.

Construction Equipment Loans

• These loans are available for purchasing new or used equipment and machinery, such as backhoe loaders, excavators, and cranes.
• The loan duration ranges from 12 to 60 months, depending on the deal and repayment capacity.
• Construction equipment loans are typically secured loans, with the machine itself serving as collateral until the loan is repaid.

SME Credit Card

• SME credit cards offer loans in the form of cash credit or term loans, with a credit limit of up to INR 10 lakhs.
• These loans are available to small retail traders, small industrial units, small business enterprises, and transport traders.
• The repayment tenure is usually 5 years for term loans and 3 years for cash credit.

Advantages of Loans

• Loans are easily accessible through financial institutions like banks, private institutions, and Non-Banking Financial Companies (NBFCs).
• Borrowers are protected from exploitation during emergencies.
• Various loan types cater to different customer requirements.
• Competitive environments among financial institutions benefit customers with lower interest rates and extended repayment periods.
• Government schemes offer tax savings and lower interest rates for loans taken at specific times.
• Banks generally do not monitor how loan funds are used as long as payments are made on time.
• Banks offer the most cost-effective loan solutions with lower interest rates.

Disadvantages of Loans

• Applying for a loan involves tedious paperwork, documentation, proof, witnesses, etc.
• Excessive and unnecessary documentation can hinder loan approval.
• Loans are not sanctioned for the complete requested amount; a ratio determines the processed amount.
• Some bank loans require collateral, making it challenging for startups and businesses without assets to secure a loan.
• Unsecured loans come with higher interest rates.
• Late payments can result in negative credit bureau reports, affecting credit scores.
• Borrowers with low credit scores face difficulties in obtaining loans.

More Articles for Banking Awareness

• Risks in Banking Sectors
• Negotiable Instruments
• National Income
• Money Market
• Money And Types
• Insurance Companies in India
• Financial Regulatory Bodies
• Structure of Banking
• Monetary Policy
• Securities in Banking Sectors

Loans in Banking Sector FAQs

What is a loan?

A loan is a predetermined amount of money lent by one party to another. The borrower agrees to repay the total loan amount, along with interest and other finance charges, in the future.

What are the main types of loans in the banking sector?

The two main types of loans in the banking sector are secured loans and unsecured loans.

What is a secured loan? What are its examples?

A secured loan is a loan where the borrower pledges some assets as collateral, such as property or a car. Examples of secured loans include mortgage loans, loans against fixed deposits, home loans, gold loans, and loans against property.

What is an unsecured loan? What are its examples?

An unsecured loan is a loan that is not backed by any property or collateral of the borrower. Examples of unsecured loans include personal loans, subsidized loans, concessional loans, short-term loans, and demand loans.