LEARN HOW LOANS WORK BEFORE YOU BORROW

Learn how loans workA loan is a form of credit facility. It is a contractual agreement in which a borrower receives something of value from a lender and agrees to repay (usually with interest) at some later agreed date.

Every loan consists of 3 different parts:

  • The Principal 
  • The Interest
  • The Repayment

The principal is the cash made available by the lender to the borrower to be repaid back at a later period.

The interest, simply put, is the extra money you pay to the lender for using the principal for a certain period of time.

The repayment is the total amount you pay to the lender at the end of the agreed period of time. This is the addition of the principal and the calculated interest. The loan repayment could be spread over a period of time, based on the mutual agreement between the lender and the borrower, to make the payback easy for the borrower.

FORMS OF LOAN

There are 2 forms of loans

Secured and Unsecured Loans

  • Secured loans are loans where borrowers put up asset(s), such as landed property or vehicles as collaterals. This gives the lender more confidence in giving the loan.
  • Unsecured loans are loans that are approved without collateral. This form of loan puts the lender at more risk.

Below are loan terms you should know before applying for a loan

1. DEFAULT CHARGE

The default charge is an additional payment the borrower pays to the lender due to failure to make the repayment as at the mutually agreed date. This is always included as a form of percentage charges on either the principal, the interest, or both principal and interest, and signed by both parties in the loan contract.

2. CREDIT HISTORY

There is a credit report for every loan borrower which shows the past loan behavior of the borrower (individual or organization). This is checked with the consent of the borrower at the point of applying for the loan.

The credit history goes a long way to give the lender an in-sight about the past record of the intended customer. Hence, as a borrower, it is advisable to maintain good records and ensure early repayment as these are important on any form of loan taken.

Your credit history determines your creditworthiness, and sometimes, your creditworthiness plays a crucial role in the interest rate and loan amount some financial institutions offer you.

3. INTEREST CALCULATIONS

Different financial institutions have their methods of calculating interest rates. Some of these  include:

SIMPLE RATE: This is always multiplied to the principal at each payment period to find the interest due.

COMPOUND RATE: This charges interest on the principal and on the previously earned interest. For example, if you borrowed  100,000 at the rate of 5% per annum. You would owe 5,000 interest in the first year. In the second year, you would owe 110,250 as your interest would be calculated as 5% of 105,000. 

AMORTIZED RATE: This is designed in such a way that the borrower pays a larger part of the interest from the beginning of the repayment than the principal. And over time, the amount of the principal in each payment will increase, bringing down the principal and amount of interest charged on the principal.

FIXED RATE: This rate is stated upfront and it stays the same over the period of the loan.

VARIABLE RATE: is can also be called an adjustable rate. This rate changes over the life of the loan to reflect changes in the market interest rate. In order words, your interest rate could go up or down over the term of the loan. 

4. PAYING DOWN YOUR LOAN

A loan that is ordinarily supposed to run for 6 months could be paid down in advance, depending on your income projections, or the achievement of the purpose of the loan. Paying down your principal and wrapping up a loan quickly, means you can save money that you would have spent on interest payment to the lender.

In conclusion, just before you make the final decision to apply for a loan, try to determine the following:

  • The loan purpose: What do I need the loan for?
  • Is there any other way I can raise money at this time without taking a loan in order to save myself from paying interest?
  • Do I have any running business that can pay back this loan in case anything goes wrong along the line with the loan?
  • Do I have enough experience in the business I need this loan for?
  • What is the appropriate period I can make use of the loan?

Once you are able to ask yourself these questions and more, and you are convinced within yourself, then, you can act accordingly.

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