Meaning of Loan

A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of
financial assets over time, between the lender and the borrower.

In a loan, the borrower initially receives or borrows an amount of money, called the
principal, from the lender, and is obligated to pay back or repay an equal amount of
money to the lender at a later time. Typically, the money is paid back in regular
installments, or partial repayments; in an annuity, each installment is the same amount.
The loan is generally provided at a cost, referred to as interest on the debt, which
provides an incentive for the lender to engage in the loan.

All loans, no matter what they are, are either secured or unsecured.

Secured Loans

These are secured (or borrowed) against an asset you own, such as your home, which is
offered up as collateral. Ultimately if you default on the loan, the bank will get their
money back by way of foreclosing your house (or otherwise seizing the collateral).

The interest rate should be very low (and often negotiable), hovering close to prime rate.
The better your credit rating is, the more bargaining power you have with the terms,
including loan amount and repayment period.

Payment terms are flexible, and can even be structured as “interest-only.”

If the loan is secured against the equity in your home, the application process usually
involves a “drive by appraisal” of your home and some legal fees, that together amount to
a few hundred (up to a thousand) dollars. As such, it’s usually best to apply for a higher
loan qualification amount than you think you need (as long as you know yourself well
enough not to get into more debt unnecessarily). This way if you wish to borrow more
money later on, new appraisals and legal fees can be avoided.

Examples of secured loans:

• Car loans
• Boat (and other recreational vehicle) loans
• Mortgages
• Home equity loans
• Home equity lines of credit

Unsecured Loans

These are (as they sound) not secured against any assets. The bank can only utilize
collectors (and freeze your accounts) if you default.
The loan amount granted is largely attributable to your credit history and
income/assets/debts at the time of application. There is a considerably higher assumption
of risk on the bank’s part with an unsecured loan. Thus, the interest rate is much higher.

Examples of Unsecured Loans:

• Personal loans
• Personal lines of credit
• Student loans
• Credit cards/department store cards

Loan Types:

There are a few different ways the bank can lend you money.

Line of Credit

Similar to a credit card, you are given a maximum allowable balance, and each month
you can borrow as much as you wish from the line of credit up to the maximum.

Monthly minimum payments vary from a percentage (e.g. 3%) of the outstanding balance
(as for most unsecured lines of credit), to as little as interest only (as for some secured
lines of credit).

You can pay as much as you wish above the minimum payment amount, whenever you
wish.

Some lines of credit come with checks, or can be linked to your bank card for debit
transactions.

Can be secured or unsecured.

Conventional Loans

Conventions loans include personal loans, home equity loans, car loans, etc.

The repayment terms and amortization is pre-determined and consistent. For example, a
$5,000 loan payable over 3 years in equal payments at 8% interest.

You cannot add to this loan without applying for a new loan entirely.

You can usually pay off the loan faster than schedule without penalty.

Monthly minimum payments will often be higher than they would with a Line of Credit,
due to the shorter amortization (period of time to pay it back).Can be secured or
unsecured.
Mortgage

Mortgages are always secured loans, with the collateral usually being real estate. They
are for large amounts of money, and are payable over long periods of time.

Maximum amortizations (repayment periods) for a mortgage range from 25 to 30 years,

depending on where you live.

You can borrow up to a certain percentage of the appraised value of the property, subject
to some restrictions and insurance provisions.

Interest terms can be either fixed or variable. Fixed interest locks your rate in for a fixed
period, typically five years. Variable interest rates will fluctuate with the prime rate, and
have little to no lock-in period.

The penalty to break a fixed rate mortgage mid-term can be outrageous. So if the interest
rates go down dramatically, you are stuck with the rate you have until the term (e.g. five
years) is up. On the flip side, if the interest rates go up dramatically, your interest rate is
protected for the duration of the term.

All the interest is paid up front. In the first few years of having a mortgage, almost all of
your payments are comprised of interest, with only a few dollars reducing the principal. It
is not until the later years of a mortgage that the reduction of your principal loan amount
picks up momentum.

Although you can’t always repay as much as you wish, you can usually make additional
payments which directly reduce your principal loan amount.

Credit Cards

Known in some circles as the antithesis of all things good and pure, credit cards tend to
get a bad rap. Depending on how they are used and abused, they can admittedly be bad
news.

You are allocated a maximum balance, with freedom to charge as much or little to it
within the limit.

Standard credit cards are always unsecured, so the interest rate is high: usually 9-19%
(with the average being closer to 18%)

The minimum payment is usually quite small — expressed sometimes as a percentage of

the outstanding balance, but in some cases it is little more than just the interest.

If you pay off the balance in full before the due date, you are not usually charged any
interest (this depends on the credit card).
Whether you’re planning to start a new business or thinking of expanding your current
business, applying for a business loan from the bank can help you speed things up.

Leveraging on credit is one of the best tools for business growth. Simply saving up for
that start-up capital or waiting for your business to generate those additional funds can
take a long time.

In most cases, capturing emerging trends is an essential part of business success. When a
good opportunity comes, don’t let the lack of money or capital stop you from taking
action.

There is a general perception today that credit is tight — which some bankers might
argue is an optical illusion. They will contend it's more a demand issue than supply —
that many businesses are cautious and not applying for loans — because banks have
plenty of money to lend. If supply is not the issue and the perception of tight credit
persists nonetheless — what gives? When you consider the five C's, it becomes clear that
banks have, for the most part, simply returned to the basics of credit underwriting

So the question now is, how do you know if you’re eligible to apply for a loan, a business
loan in particular? Here’s a simple guide to assess yourself.

In the world of finance, there is the Five C’s of Credit Analysis. These are the five
components that banks, cooperatives and other lending institutions usually use to evaluate
credit worthiness. Let’s discuss about the five C’s.

Five Cs of Good Loan

A method used by lenders to determine the credit worthiness of potential borrowers. The
system weighs five characteristics of the borrower, attempting to gauge the chance of
default.

The five Cs of good loan are:

-Character
-Capacity
-Capital
-Collateral
-Conditions

“5-C” is a very important part to evaluate a customer to whom Bank is going to sanction
loan. This “5-C” analysis is most widely used in banking sector. The five Cs represent the
“Thou Shalt” commandments of lending, the core of sound commercial banking.
Character

The first factor is character, which refers to a borrower's reputation. Thou Shalt make
sure that the company or person you are lending to is of outstanding character. Character
is basically the general impression that you give to your potential creditors. They will ask
themselves questions like: Are you trustworthy? And will you really pay back the loan?
Or will it become bad credit loans for them?

To help them create a more accurate profile, they can look into your educational
background and business experience. They might also ask and talk to your references.
But most of the time, they’ll first and foremost, look into your credit history and check if
you have mishandled accounts, delinquent credit cards and past due loans from others.
Lastly, they’ll also check if there have been legal cases filed against you, your partners or
your business. A man of character will face an adverse situation with courage and
fortitude and will not exaggerate the turn of his fortune and the calamities in order to
secure concession from the bank in terms of remission of interest or even loan
forgiveness. That shows the strength of his character which includes such traits as honor
and trustworthiness.

Capacity

Capacity measures a borrower's ability to repay a loan by comparing income against

recurring debts. This is considered as the critical of the five C’s. Banks will look into the
financial statements and records of your business to see how it is doing. For those
venturing into business for the first time, they’ll look into your income status, personal
credit history and current assets and liabilities to evaluate your eligibility.

If a company is not making money or generating a positive cash flow, there will not be
enough money to pay off its debt. Remember bankers are in the business of getting paid
back for the loans they make. And the applicants will try to give you the impression that
they are the most capable business people around.

Capital

This is the money you have personally invested into the business and can be seen from
your financial records. This is important for the bank because it shows the level of
confidence you have for your business. Why would they risk their money if you yourself
have “nothing to lose” if the business fails?

For those who really have no money to fund their business, your “capital” would be your
business plan. A clear, comprehensive and well-researched business plan shows how
much dedication and passion you have for the business. This is something that lenders
and investors will expect from you, so make sure to prepare a good business plan.
Collateral
Collateral, such as property or large assets, helps to secure the loan.
In most cases, the bank wants the loan amount to be exceeded by the amount of the
company’s collateral. The reason the bank is interested in collateral is as a secondary
source of repayment of the loan.

A secured business plan will usually have lower interest rates. That’s why you should
seriously consider if you can offer a collateral for your business loan. Your collateral can
be machinery, equipment and other business assets. Furthermore, you can also opt to
pledge your real estate properties and other personal assets such as your car.

If you have no collateral to present, then you’ll most likely get a higher interest rate or be
approved only with a small amount for your business loan. In some cases, this is not
necessarily a bad thing. It really all depends on how much you really need and for what
purpose you need it.

Conditions

Finally, the conditions of the loan, such as the interest rate and amount of principal, will
influence the lender's desire to finance the borrower. Another key factor in the five C's of
credit is the overall environment that the company is operating in. The banker is going to
assess the conditions surrounding your company and its industry to determine the key
risks facing your company, and also, whether or not these risks are sufficiently mitigated.
Even if the company’s historical financial performance is strong, the bank wants to be
sure of the future viability of the company. The bank won’t make a loan to you today if it
looks like the viability of your company is threatened by some unmitigated risk that is not
sufficiently addressed.
Five Cs of Bad Loan
These traditional Cs of loan should be thought of as commandants: Do this, check this,
and look for that. These rules have worked fairly well in the past, but in recent years,
bankers have learnt a few more Cs-the five Cs of bad loan. The five things of bad
loan to guard against the lessons learnt from the most recent lending mistakes.
To prevent another breakdown in the commercial lending system from occurring, it is
necessary to add the five Cs of bad loan. These are considered as “Thou Shalt Nots” or
the second five commandments of lending. They are:

-Complacency
-Carelessness
-Communication
-Contingencies
-Competition

Complacency

This is one of the most important lessons to be drawn from the past few years and is to
guard against complacency. Many bankers have said something like, "I don't need to
worry about that borrower, he has always paid us on time"- that is obviously an incorrect
assumption. Three things can influence to make complacency. First, overreliance on
guarantors has been a problem. Bankers who accepted those "solid" personal guarantees
are creating worsening conditions. Second, overemphasis on past performances is another
concern. The old adage that past success is very true. But it was ignored. Third, over
reliance on large net worth is yet another concern. This is simply "good old boy" lending.

Carelessness

The second rule of bad credit, or mistake to be learnt from is, carelessness. It was easy to
say, "Don't worry about the loan documentation. I will get later." There are a lot of loans
with improper documentation, incomplete of conditions precedents (CPs), incomplete
financials and inadequate loan appraisal and no one knows where to find the information
because the officer responsible is no longer working for the bank and it is all because
someone was careless. A lender must be aware of the following facts:

l Lack of current financial information (minimum three years audited financial

statement).

l Personal Net-worth statement.

l Lack of protective loan instruments.

l Information not kept in files.

Communication
A communication breakdown is a simple problem, but it can easily destroy a whole bank.
Poor communication, up and down the line, is deadly. For up-standard the
communication system, a lender must concern about credit quality objectives and
upward communication system. Credit quality can be judged through various
information software in this modern IT era. So, IT knowledge is very much essential
for all credit officers. Without IT knowledge, it is not possible to communicate
properly for better judgment of credit proposal in this 21st century which is called
"the century of technology".

Contingencies
Many bankers may think that they are the brightest financiers, but no one looked at what
would happen to his or her loan if the economy slowed down. Bankers are supposed
to look at every bad thing that may happen and then decide how likely it is that and
of those things will happen.

Competition
Competition is probably the most important of five Cs of bad credit. Bankers decided to
win the business decide to win the business. Unfortunately, that meant making his or
her credit standard as loose as or looser that everyone else's. The Banker must think
how his/her product can be sold to the consumers and consumers will buy only this
bank's product not another Bank's (competitor) products.

Last C -- Co-operation: This C can solve all the problems of bad Cs. This is Co-
operation. Co-operation from and to each other both lender and borrower which may
drive any credit facility the good and bad credit also.

Building and Maintaining Good Credit Rating

Over the years, the percentage of cash transactions has steadily declined and your
purchasing power is now mostly determined on your ability to raise credit. Therefore, bad
credit not only impairs you financially but also psychologically as your purchasing power
drops sharply. Building and maintaining good credit rating is important as it sends vital
signals about your reliability, responsibility and dependability to your creditors,
employers, landlords, marketers, insurance companies, mobile phone operators, etc. The
good news is that with little planning and care you can build and maintain a good credit
rating. Understanding how a good credit history is established and maintained will help
you avoid some of the pitfalls that lead to bad credit.
Building a credit history

If you are a new player in the credit market and do not have a credit history, you need to
build one. A good credit history is built gradually through responsible use of loans, credit
cards and other credit instruments. There are "three Cs" to good credit rating:

• Character: Your "willingness" to repay

• Capacity: Your "ability" to repay
• Collateral: Your available "assets"

By using credit cards for your expenditures and paying the full billed amount on time,
you can demonstrate your willingness to repay loans and establish a good credit standing.
Some of the tips to build your credit rating are:

• Start with gas cards. Get 1 or 2 gas cards and use them for all your gasoline
purchases. Pay the full amount of your card bills well in advance and continue
doing so. Since gas credit cards are relatively easy to obtain, they are a good start.
• Put your house and utility bills in your own name and pay them on time to
establish good credit history under your own name.
• Pay other bills such as rent, taxes, mobile phone, insurance, cable etc. on time as
your credit report may contain information on any late- or non-payments for these
bills.
• Budget your expenses and stick to that. Inculcate habit for small savings.

The above four steps will help you to establish a credit history. Once you have
established some credit history, apply for a secured credit card. Pay all your expenditures
with your secured credit card and ensure that you clear the credit card dues well in time
and in full. Continue to do so for next 6-12 months. After about a year, when you have
enough credentials on your credit report, move on to credit card with more attractive
terms and features. Close all your retail, gas and secured cards.

Maintaining a good credit history

Establishing a good credit history is just the beginning. It is necessary to maintain it to

enjoy the rewards of good credit rating. Maintaining your credit rating is managing your
money. Some tips to maintain your good credit rating are:

• Financial Planning: Make a personal financial plan for yourself. Stick to this
plan and have periodic reviews to avoid frequent contingencies or fire fighting.
Open checking and saving accounts to show stability and maintain significant
balance in them
• Financial Discipline: Avoid approaching creditors frequently as it may be
misinterpreted as a sign of bad or poor credit situation. Avoid debt over burden.
Reduce your debt burden by closing unused credit card accounts and
 consolidating your balances. Having too many credit cards may affect your credit
rating. Use your credit cards well below the credit limit. Touching the credit limit
too often can impact your credit rating. Avoid using one credit/loan to pay off
other credit/loan.
• Repayment discipline: Show discipline in repayment of all your obligations such
as credit card bills, loan repayments, rent bills, mortgage payments, utility bills,
service/product bills, taxes, etc. and build a character for yourself. At least pay the
minimum amount due well before the payment date, if you are constrained to pay
the full bill. In case you miss any payments, pay them as soon as you get
notice/reminder from the creditor and get all your accounts up to date.
• Responsiveness: Don’t ignore any notice/reminder from the creditors regarding
late payment or non-payment. Contact them immediately to resolve the problem.
Communication with
• Debt consolidation: Small minimum monthly payments required for each credit
instrument generally adds to a large figure. By consolidating your debt, you can
reduce your monthly payments substantially and can easily avoid the bad credit
problems. In general, debt consolidation loans also carry a lower interest rate, thus
you will save substantial amount on the total cost of the loan itself.
• Periodic review: Review your credit report periodically and report any errors
immediately to the credit bureau for correction.
• Seek help: If you feel that the things are getting out of your hands, seek help from
your creditors to extend the date of repayment or restructure the terms of your
credit. Take help from qualified credit counselor to help you better manage your
debts.

Overall, understand your credit report and figure out where you stand. Plan according to
your credit bearing capacities. Build your character to establish and maintain a good
credit history.

Only by joining the five Cs of good credit- character,capacity, conditions, capital and
collateral, with the five Cs of bad credit- complacency, carelessness, communication,
contingencies and competition, can bankers be sure of not falling into the same traps
that have tripped them up for years. The Cs provide a way to avoid being the grizzled
veteran with lots of war stories.

Therefore, lenders, heed the ten commandments of good loans and five commandments
of bad loans.