10 Key Terms You Should Know Before You Apply for a Loan

Introduction

If you are in the process of availing a loan and you are confused so many financial tems, it is time for a quick lesson in loan terminology to help you make the best possible decision. Instead of making Google your second home while you navigate the process of applying for a loan, understand a few key terms that will help you get clarity about the technicalities of this process.

Here is a list of 10 loan terms you need to know to avoid confusion while you look for the perfect loan product.

Loan-to-Value

Loan to value (LTV) ratio is the proportion of the value of the asset, which the lender can finance through a loan. Every lender has a prescribed LTV ratio for each loan category that they cannot exceed while sanctioning a loan.

For example, Hero FinCorp has an LTV of up to 95% in the two-wheeler loan segment. This means the borrower can get up to 95% of the value of the two wheeler as a loan for his/her new purchase.

For lenders, the LTV ratio helps in assessing the risk involved before they sanction a loan application.

Credit Appraisal

It is the process through which your lender evaluates the technical feasibility and economic parameters of approving any loan. It includes evaluating the creditworthiness, employment status, income stability and financial position of the applicant.

The lender assesses the risk quotient and ability to repay the loan within the stipulated time through the process of credit appraisal.

Credit Score

A three-digit score that reflects your creditworthiness and helps financial institutions to review your loan application. The score is based on your past credit behaviour and debt history, and ranges from 300 to 900. The range of credit score is usually divided into three parts and is categorised accordingly.

A borrower with a low credit score may find it difficult to get their loan application approved. Whereas, a loan applicant with a good credit score has a high chance of getting a loan, or with relatively lenient terms and conditions. Under the excellent category, the likelihood of your loan application getting approved with favourable terms is the highest.

Processing fee

Processing fee, also called administrative fee, is a one-time fee charged by the financial institutions to sanction the loan application. It usually varies from 0.5-5% of the total loan amount.

Floating Interest Rate

Floating interest rate means that the interest rate on your loan is subject to revision every quarter for the duration of the loan tenure. The interest rate is linked to MCLR (Marginal Cost of Funds based Lending Rate), which is calculated by the RBI and your floating interest rate is updated accordingly.

Credit Utilization Ratio

The credit utilization ratio is referred to as a percentage of the debt you are using compared to the available credit limit. It mainly focuses on revolving credit like utilization of credit card balance, line of credit offered by financial institutions to businesses etc. 

A higher credit utilization ratio indicates greater dependence on debt and negatively impacts your credit score. Therefore, a person with a low credit score is always suggested to keep a low credit utilization ratio to improve the credit score. 

Hypothecation

Hypothecation means offering your assets to the lender as collateral without losing the ownership title and rights of the asset. However, in case you default on your loan payment, the lender reserves the right to seize the assets and recover all dues. Hypothecation is especially done while financing a movable asset like a vehicle.

Pledge

Under the pledge, the lender keeps the possession of the asset owned by the debtor as security for the loan given. Under this category, all types of assets, movable or immovable, are considered by the lender. In case of default, the lender reserves the right to sell the asset and recover the due amount from the sale proceeds. 

Lien

Lien is a form of security, where the creditor keeps the legal rights of the property belonging to the borrower until the loan is repaid. However, the borrower keeps the right to possession of the property. Compared to pledge or hypothecation, the lender does not have the right to sell the asset in case of default. 

For example, a car loan, where the vehicle is owned by the lender until the loan is discharged.

Prepayment Penalty

Prepayment penalty occurs when the loan is paid-off before the end of the term, which results in the loss of interest amount for the financial institution. The penalty charged is a percentage of the remaining loan amount or the interest amount that is due before full payment.

Conclusion

These loan terms may seem complex and tough to understand but are a necessary tool to help you attain complete clarity on what the terms of your loan are. This is why it is time to stop fretting over this jargon and let this quick crash course help you make well informed decisions when it comes to taking a loan.