Terms of Credit
Every loan agreement specifies an interest rate which the borrower must pay to the lender along with repayment of the principal. In addition, lenders may demand collateral (security) against the loan.
Collateral is an asset the borrower owns — such as land, a building, a vehicle, livestock or bank deposits — which is used as a guarantee to the lender until the loan is repaid. If the borrower fails to repay, the lender has the right to sell the collateral to recover the money.
The Four Terms of Credit
Interest rate, collateral, documentation requirement and the mode of repayment together make up the terms of credit.
Consider Megha's house loan: she borrows Rs 5 lakh from a bank at 12 per cent annual interest, to be repaid in 10 years in monthly instalments. She submits documents (employment records and salary), and the bank keeps the house papers as collateral, returning them only when she repays the loan with interest.
The terms of credit vary substantially from one arrangement to another, depending on the nature of the lender and the borrower. Borrowers look for easy terms — a low interest rate, easy repayment conditions and less collateral and documentation.
Questions and Answers
Q1. What are the terms of credit? Name the four components.
Answer: The terms of credit are the conditions on which a loan is given. They have four components: (i) the interest rate; (ii) the collateral (security) demanded; (iii) the documentation requirement; and (iv) the mode of repayment. Together these decide how easy or difficult a loan is, and they vary from one credit arrangement to another.
Q2. What is collateral? Why do lenders ask for it?
Answer: Collateral is an asset owned by the borrower — such as land, a building, a vehicle, livestock or bank deposits — that is pledged as a guarantee to the lender until the loan is repaid. Lenders ask for collateral so that, if the borrower fails to repay, they can sell the collateral to recover their money. It protects the lender against the risk of non-repayment.
Q3. In Megha's house loan, identify the interest rate, collateral, documentation and mode of repayment.
Answer: For Megha's loan of Rs 5 lakh: the interest rate is 12 per cent per year; the collateral is the papers of the new house (kept by the bank); the documentation required was her employment records and salary details; and the mode of repayment is monthly instalments over 10 years. These together are the terms of credit for her loan.