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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.
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.
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.
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%.
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.
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.
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
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
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?
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
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.
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.
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.