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Tata Capital > Blog > Generic > What is a Loan? A Simple Explanation for Beginners

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What is a Loan? A Simple Explanation for Beginners

What is a Loan? A Simple Explanation for Beginners

There are times when purchasing with cold, hard cash is not possible. Either you do not have that much money, or you can't deposit such a huge sum at once. Does that mean that you should let go of a good deal?

To solve this problem, the financial world developed the concept of loans. It is one of the most prominent tools that can help you better control your finances if used right. But how exactly do loans work, and how do they aid you in achieving your financial goals?

If you've ever pondered this question, you're in the right place. In this article, we will be demystifying the whole loan process and find out how do loans work by better understanding this age-old financial tool.

What is a loan?

A loan is a sum of money lent to you by financial institutions, like banks, NBFCs, or private lenders, with your promise to repay it over a specific period. In return, the lender charges a particular interest you are expected to pay on top of the borrowed amount.

Think of it as a financial agreement: you receive upfront capital to meet immediate monetary needs, and in return, you commit to repay the amount (principal) with additional interest.

Loans have a wide range of use cases. You can use the borrowed sum to purchase a home, finance education, meet unexpected medical expenses, deal with emergencies, expand your business, or make simple luxury purchases.

Loan process explained

The loan process typically involves several key steps:

Application: You start by filling out a loan application for your chosen financial institution. The application form typically includes personal information, income details, and the purpose of the loan. The lender uses this information to evaluate your creditworthiness and make a call on whether you qualify for the loan.

Evaluation: Once you provide your details to the lender, they will evaluate your creditworthiness. This is usually done by performing a credit check to review your credit history.           

Approval: After matching your profile with the lender's requirements, they decide whether to approve or deny your loan request. If approved, you'll receive a loan offer detailing the loan amount, interest rate, repayment terms, and other associated fees.

Acceptance: If you formally accept the loan offer, the lender will transfer the promised amount to your account. The time taken for loan disbursement depends on the loan type. Personal loans can be paid within a few hours, while home loans can take longer.

Repayment: After receiving the funds, you are responsible for making regular payments according to the pre-determined repayment schedule. Prices typically include both the principal amount borrowed and the interest accrued.

Types of loans

Loans come in various forms, each tailored to specific needs and circumstances. Loans can be divided from the lender's and borrower's perspective; let us have a look at each of them:

From the leader's perspective, loans can be of two types:

1. Secured Loans: Secured loans are financial arrangements where borrowers offer collateral, such as a home or a vehicle, to back the loan. This collateral provides a safety net for lenders, reducing their risk and allowing for lower interest rates and higher borrowing limits.

2. Unsecured Loans: Unsecured loans, on the other hand, do not require collateral. These loans are granted based on the borrower's creditworthiness, income, and financial history. Since no asset backs the loan, unsecured loans usually have a higher interest rate and lower borrowing limits.

From the borrower's perspective, loans can be of the following types:

1. Personal Loans: These unsecured loans are versatile and can be used for almost any purpose, from consolidating debt to covering medical expenses. Since these loans are not collateral, the lender approves the loan based on your credit score.

2. Home Loans: Home loans are a type of secured loan used to purchase real estate. In the case of a home loan, the property itself serves as collateral.

3. Student Loans: These loans are designed to help cover the cost of education, including tuition, books, and living expenses. Student loans offer a lower interest rate and flexible repayment terms.

4. Business Loans: Business owners can secure financing to start or expand their businesses. These loans come in various forms, including small business loans, equipment loans, and business lines of credit.

Secured Vs. Unsecured Loans

Let us unravel the key differences between the two major types of loans:

Secured LoanUnsecured Loan
These loans are backed by collateral.These loans do not require collateral.
These loans carry a low risk for the lender; the interest rates are also lower.Unsecured loans are riskier for the lender. Hence, they come with higher interest rates.
These loans are easier to approve because of their low riskThese loans are more difficult to be approved. The borrower's credit history plays a major role in approval.
Examples: Home loans and car loansExamples: Credit cards and personal loans

Benefits of loan

Loans have emerged as one of the most prominent financial services because of the following benefits they offer:

1. Access to Funds: Loans provide immediate access to a lump sum. With the help of the extra fund, you can easily achieve your financial goals or cover unexpected expenses.

2. Build Credit: Responsible use of loans can help build or improve your credit history. This, in turn, boosts your credit score and makes it easier for you to qualify for future loans or credit products.

3. Financial Flexibility: Loans provide the liquidity to make big purchases or investments without waiting years to save up. Because of this flexibility, you can seal a good deal at the right time and reap benefits from future acquisitions.

4. Tax Benefits: Some loans, especially home loans, come with tax deductions on the interest paid. According to section 80C of the Income Tax Act, you can get a deduction of up to 1.5 Lakhs INR on housing loan repayments.

Parting words

When understood and utilised judiciously, loans can be instrumental in turning dreams into reality. They bridge the gap between aspiration and achievement, ensuring financial constraints don't hold you back. However, lending money from registered institutions and looking at the fine print before accepting a loan is crucial.

Need a quick personal loan? Look no further than Tata Capital. Tata Capital offers a complete digital process, competitive interest rate, speedy approvals, and robust customer support, and ensures that your needs are financed within a few minutes. Apply for a loan today! 

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