Engineer's Finance

Loans are very common these days. There are various kinds of loans; most common ones are Housing loan, Personal loan, Educational loan, Credit Card loan and Vehicle loan.  Except the housing loan most of the loans have a short term period for repayment. It is very critical for the banks to get the money back from the borrowers and ensure the smooth working of the banks. When bank can make more money by giving it for long term why does it prefer to keep the term short for other loans other than the housing loan?

Banks or a financial institution that provides loans for people are risking their own money or the money they have been trusted with from the customers. For a bank, a borrower is more important than a depositor since a borrower will be giving in more money than the depositor. But the banks have to be cautious with the money that they give it to borrower since there is a risk involved, the chances of repayment is at stake. The risk that is taken by bank is very well calculated and also the borrower’s repayment capability is also taken into consideration.

For personal loans and other kind of loans, why is it short term? From a bank’s perspective, it is risking its money by giving it to borrower instead of keeping it Reserve Banks of the nation. The intension is to make more money than that. The intension is simple, get the money back as soon as possible. If you observe the short term loans are given based on your salary alone with no collateral security. This is risky for banks but the banks think this is worth their risk. Generally the EMIs will be higher for shorter term loan.

If I want to borrow one lakh then the bank will check for my salary slip and my residential details so that it can gauge my repaying capability. If the banks think I can borrow the money then it can approve the loan for me. Assuming that I repay back within one year then the EMI would be close to Rs.10,000 if the interest rate is 12%. Now banks don’t really care about only my loan, it would have lent money similarly for 10 more people. Assume that all the 10 people including me have taken 1 Lakh loan and each of us has to pay Rs. 10,000.

This is the best part, at the beginning or end of the month, the bank collects Rs. 1 Lakh and this money is again lent to other person. From the second month, the bank collects Rs.1,10,000 for the same principal amount and again it lends a lakh to other person and going this way bank collects 3^rd month Rs. 1,20,000, 4^th month Rs. 1,30,000, 5^th month Rs. 1,40,000, 6^th month Rs. 1,50,000. At the end of six month bank has given a loan of 16 lakhs with the principal amount 10 lakh, and it has a profit of 10k+20k+30k+40k+50k = Rs. 1,50,000. Bank can again give this money to other borrowers or keep it as reserve.