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Why should you borrow?

Few people can pay for everything they need with money taken from savings. But many more people can afford those purchases when they include borrowing as part of a sound financial plan. Borrowing provides an effective bridge between your income & savings on the one hand and expenses on the other.

Borrowing in simple words is taking money or cash from an institution with a commitment to pay this amount back over a period of time with interest. There are two parties to any borrowing transaction – the lender or bank and the borrower or customer. These two parties come together and agree, through a contract or by acceptance of terms and conditions, on the loan amount, the interest rate and the tenor (term) of the loan. The interest charged by the lender is cost of the loan expressed in % terms, which will vary for different products and banks.

Borrowing money requires three key elements: ability to repay, steady income and discipline.

 


 

Ways to borrow

An educated borrower is a prepared borrower. That education covers not only how credit works, but also what loan options are available and which ones are best suited.

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Personal Loan

A personal loan is for your ‘personal’ use. A personal loan is cash that can be used for any purpose (unlike a home loan or car loan which have a specific end-use). Personal loans are typically taken for home renovation, purchase of household durables, financing your holidays or higher-education etc. There is no down-payment requirement from the borrower and the loan tenors are up to 4 years.

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Car Loan

Car loan is a means of financing the purchase of a car or vehicle. Car loans are also secured by nature of the car / vehicle being the collateral. These loans also require a down-payment of around 20% and are typically given for shorter periods, of up to 5 years. The ratio of loan amount to the purchase value of the car is the Loan-to-Value (LTV) and is typically around 80%.

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Credit Card

A credit card is a popular borrowing product and comes with the advantage of a payment mechanism – a plastic which is called a credit card. These cards are universally accepted around the world by shops and other establishments as an alternative to cash payment. A credit card is essentially a thin piece of plastic, issued by a bank or financial institution that authorizes the person named on it (the ‘cardholder’) to make purchases up to a pre-decided (by the bank) credit limit without needing to make an actual payment at the time of purchase. It thus provides the easiest way to ‘SPEND NOW, PAY LATER’ for purchases made at supermarkets, department stores, hotels & restaurants, for air/rail tickets, for telephone and utility bills, school fees or fuel etc. The bank, on a periodic basis (usually, once a month) sends the cardholder a billing statement that provides an itemized list of all such purchases (when, where and the amount) with an ‘amount due’ and ‘due date’ by which the cardholder needs to make the payment.

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Home Loan

A home loan is essentially a way to finance the purchase of your dream home. These are typically large amounts, and as such are paid back over longer period of time (generally up to 25 years). The bank or lender typically requires the customer to make a cash down-payment which is the customer’s equity or commitment and is usually in the range of 20-25% of the value of the home. The balance amount is the home loan. The ratio of loan amount to the value of property purchased is known as Loan-to-Value (LTV). Given the large loan amounts, home loans require ‘collateral’ or ‘security’ to protect the bank’s interests – this collateral is the home itself.

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Overdraft

An overdraft is a borrowing facility linked to a bank current account. Overdrafts are designed to help manage short term borrowing short, when you need to pay money out (for example, to purchase raw materials) before receiving money in from sales. An overdraft is a working capital facility and could be an excellent way to cover Short term cash flow needs to meet unforeseen requirements. Overdrafts are flexible – they offer instant access and can be used just when they’re needed. Overdrafts are cost effective – interest is only paid on the amount borrowed

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Business Loan

A business loan is an amount of money borrowed for an agreed period of time with an agreed repayment schedule. The repayment amount will depend on the size and period of the loan and the applicable rate of interest. These loans are more suitable than overdrafts for longer-term finance needs

 


 

Golden rules of borrowing money

1
Clear purpose – Why would you need to borrow?

Borrowing helps you meet important financial goals that might not be otherwise possible e.g. when you wish to buy your own house, a home loan can help you finance the purchase. Similarly, you may also need to borrow cash or ‘take on credit’ for other planned expenses e.g. buying a car or sending your child to a foreign university or even unplanned ones, such as urgent medical expenses. And finally, sometimes borrowing is just a sensible thing to do as it allows you to make purchases or incur expenses without needing to make the payment upfront. It is imperative to prioritize needs & decide to borrow towards most important needs. Is the product or service necessary to borrow for? Is there a way to afford this purchase without borrowing money?

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Which product to choose?

Depending on the purpose, banks typically offer a number of products that you can use to borrow sensibly and meet your needs. The need / goal should be clearly categorized & mapped against the available products. Time horizon of repayment can also be a good guiding principle while making the decision. Be clear on the purpose of borrowing e.g. a home loan is best suited for financing a home purchase

3
Be aware of the cost

Be aware of the interest rates, fees & other charges associated with the loan: Ensure that when you apply for a loan, the bank clearly explains the interest rate, processing fees, early payment charges etc. Similarly in the case of a credit card, be aware of annual fees, late payment charges and interest charged in case you do not pay the total amount by the due date. Information on interest rates and fees/charges are usually available either on the bank’s website or in the Schedule of Charges published in the bank’s branches. Always check whether you are getting the best deal, including the lowest rate and the lowest fees and terms of payment.

4
Be aware of the cost

Be clear on what you can afford: based on the loan amount, interest rate and tenor, the installment that you will need to pay will differ. Ensure you use the cash-flow calculator (please see section on ‘SAVE’) to understand your monthly inflows e.g. your salary and outflows including fixed expenses e.g. rent, utility bills, school fees, any other loans you may be servicing.

 

An illustrative example is as below:

Monthly Cash Inflows (Salary) AED 20,000
Monthly Cash outflows AED 10,000
Surplus available AED 10,000
Set aside funds for emergency expenses AED 2,500
Maximum installment amount (based on the above) AED 7,500*

 

* UAE Central Bank regulations require banks to cap the borrowing amount to a maximum value subject to monthly repayments not exceeding 50% of customer income.

 

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Be responsible

Make payments on time: in order to maintain a clean track record with the bank, it is essential that you pay the amounts due on time. In the case of a fixed-tenor loan, the installment is typically recovered from your bank account based on an instruction that you have given at the time of loan application. In the case of a credit card, the monthly bill that you receive will have the ‘total amount due’ and the ‘minimum amount due’ (typically 5% of total amount due) and you will need to make at least the minimum due payment on time to keep your record with the bank intact. In some countries (and soon in the UAE as well), banks share information on their loan & credit card customers with institutions known as ‘Credit Bureaus’. Based on this information, these bureaus collate and monitor the borrower’s credit history i.e. they keep a record of other loans or cards the customer may have with other banks. By not making payments on time, your credit history will be adversely affected and this may result in your not getting further loans next time you apply. Further legal action can also be initiated by the bank which is in line with the terms and conditions defined in the contracts.

 


 

Getting it clear – Frequently used terms

Principal:
The amount loaned out to the customer and recovered through the EMI
Interest:
The cost of the loan given, expressed in %. This can vary based on loan type
EMI:
Equated monthly installments: the amount that you need to pay, inclusive of both interest and principal, on a monthly basis.
APR:
Annual Percentage Rate. This term is specific to credit cards and is essentially the interest charged on unpaid amounts. It too is expressed as a %.
Amortization:
The manner in which repayment of a loan is planned by the bank using EMIs covering both principal and interest.
Debt-to-Income-Ratio (DTI):
Also known as the Debt-Service Ratio or Debt-Burden. It is calculated as the sum of all the EMIs a customer is paying across all loans divided by total monthly income.
Down Payment:
Money paid by a buyer from his own funds for certain loan types e.g. a home loan or a car loan, as opposed to that portion of the purchase price which is financed.
Loan-To-Value Ratio (LTV):
Typically expressed as a % and reflecting the relationship between the amount of the Home Loan and the value of the property. A LTV ratio of 80 means that a customer is borrowing 80% of the value of the property and paying 30% as a down payment. Also used by banks when offering Car Loans.
Mortgage:
Creation of a lien/pledge through a legal document between the lender (bank) and borrower. Through a mortgage, the borrower pledges his property to the bank as collateral for the repayment of the loan. Often this term used is to describe the loan itself.
Easy Payment Plans (EPP):
Using these plans, credit cardholders can split a large purchase e.g. buying a LED TV, air tickets or jewelry, into easy installments of up to 36 months at a nominal interest rate. A variant of the same product is the 0% EPP where the cardholder pays interest but is instead charged a processing fee.
Balance Transfer (BT):
The process by which a credit card holder can transfer his outstanding balances on one credit card (with a high APR) to another (with a lower APR) to reduce the burden on cardholder finances.
Easy Cash (EC):
Essentially a loan offered on your credit card. Using Easy Cash, you can get an amount, typically between 50-75% of the available credit limit either as a cheque or as cash directly into your bank account for a tenor that you decide. The amount is recovered in installments over the tenor through the monthly credit card bill.