Lesson Personal Finance: Lending and Borrowing Basics

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This Lesson (Personal Finance: Lending and Borrowing Basics) was created by by Shruti_Mishra(0)

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About Shruti_Mishra: I am a maths graduate from India and am currently persuing masters in Operations Research.

Lets start with the business model on which a bank works. The bank lends money to you at a certain <a href="interest_rate.lesson">interest rate</A> (say X%). Alternatively you can also deposit money in the bank and it pays you an <a href="interest_rate.lesson">interest</a> for the same (say Y%). You will find that X is greater than Y more often than not. Basically, the bank takes the money one person deposited and gives it out as loan to another person who may need the money. Bank charges higher interest for lending than borrowing and keeps the difference to itself. This is the fee that the banks get for offering its services. The basic revenue of a bank is this (X-Y)% of the total money borrowed/lend.

Lending: There are several <a href="risk.wikipedia">risks</a> which a bank faces when it lends money to someone. The <a href="risk.wikipedia">risks</a> include the default risk of the concerned party and the increase in <a href="interest_rate.lesson">interest rate</A> in economy etc. Lets learn some basic things which banks consider to mitigate this risk. One of the first things to look at is how the concerned party is going to repay the loan. i.e. the borrower's Capacity to repay. This money may come from the expected future <a href="cash_flow.wikipedia">cash flows</A> from borrower's business. The next thing banks consider before lending to a corporate borrower is the <a href="capital_(finance).wikipedia">capital</a> which the borrower himself has put in the business. This shows the commitment which the borrower has in his own business and also his capacity to pay back the loan.

For a general borrower, which may include a corporate borrower as well, the banks generally try to take hold of a <a href="collateral.wikipedia"> Collateral</a> which is a form of guarantee that the <a href="loan.wikipedia">loan</a> will be repaid. In case the borrower defaults on the payment, the bank can take possession of the collateral, which usually is a property or machinery etc., and sell it to recover part of the loan. Sometimes banks may also require a third party to provide a guarantee for the borrower. In this case, the third party is liable to pay back the <a href="loan.wikipedia">loan</a> in case of a default by the borrower.

Similarly, while depositing/lending money individuals needs to consider the best place to do so. They may lend to banks, which are safest but pay lower <a href="interest_rate.lesson">interest</a>, or they may lend directly to corporate (through <a href="bonds.wikipedia">corporate bonds</a> for instance). However, the riskiness of these bonds is higher than that of bank deposits or government bonds. This is reflected in the higher <a href="interest_rate.lesson">interest rates</a> these corporate bonds pay.

Borrowing: While borrowing money, corporate investors or individual borrowers need to be very cautious of the lender. Most of the lenders are safe, however many are not. They may charge exorbitant <a href="interest_rate.lesson">interest rate</a> to ignorant borrowers and may not direct them to the cheapest alternatives which they can avail. They may also include hidden fee and other terms which increase the cost of borrowing. Some points borrowers need to keep in mind before borrowing are:

1. One should look around for the cheapest/best loan and consult several lenders/advisors
2. Understand completer terms and check the total cost of the loan. Take special care of hidden fee and surcharges.
3. Borrow only the required amount with understanding of capacity to pay back in terms of money and time.
4. Read the loan document completely before signing. Check everything for accuracy.
5. Be cautious in dealing with uninvited loan offers and claims of limited time offers.

If one takes proper care of these things, it will reduce the chances of unwanted surprises later.

Also see:
<a href="interest_rate.lesson">Basics of Interest Rates and its uses</A>
<a href="simple_interest2.lesson">Simple Interest</A>
<a href="compound_interest2.lesson">Compound Interest</A>
<A href="simple_interest.solver">
Calculate Simple Interest, given Principal, Time and Interest Rate </A>
<A href="calc_SimpleInterestRate.solver">
Calculate Interest Rate, given Principal, Simple Interest and Time</A>