Business Loan Terms Commonly Used in Indian Banks
Looking for a business loan in India? Understanding the commonly used business loan terms first will help.
When it comes to loan schemes, the terminology used by banks may be easy to comprehend for some people but most of us find it too complex. If you are looking for a business loan, you may have come across some terms and wondering what they mean. Not understanding the terminology means that you may not be able to understand the terms and conditions of the bank for those loans, and even compare different loan products.
While it may be beneficial if the banks start presenting this information in layman terms, it is better to learn a few key terms instead of waiting for them to make the change. Today, we are going to give you 9 common terms used by Indian Banks for business loans and tell you what they mean.
Let’s get started.
#1. Fixed Interest Rate:
This is a common term but may get confusing when you see it in conjunction with the next term (floating interest rate). When you avail a loan, the bank offers it to you at the prevailing interest rate. And, if you choose the “fixed interest rate” option, the interest rate applicable to your loan will remain the same throughout the repayment period, even if it is 5-10 years. This is what used to be the norm and what people used to find acceptable when it came to loans including business loans. However, going for the floating interest rate is gaining popularity these days which brings us to the next loan term.
#2. Floating Interest Rate:
The interest rate on a business loan changes periodically if you choose the floating interest rate option. This means that the interest rate applicable to the business loan increases or decreases throughout the repayment period of the loan depending on the current lending rates of the bank. The reason it is becoming more popular than fixed interest rate is that it may decrease over time depending on the economy and consequently, reduce the overall debt burden of the borrower.
Now, you may be wondering what if the interest rate increases? Well, it is not an invalid question since this may happen. But the good news is that there is usually an upper limit to how much the interest rate can increase. Floating interest rate usually works well for long term loans since the fluctuation over time usually turns out to be beneficial for the borrower. To understand the floating interest rate better you will need to understand two terms that we cover in the next paragraph.
#3. Repo Rate and MCLR
The floating interest rate of a bank is usually pegged to the Repo Rate or the MCLR. Here is what they stand for:
Repo Rate (full form Repurchase Rate) is the rate at which the bank makes short-term borrowings from Reserve Bank of India. RBI uses the rate to control various macroeconomic factors such as credit availability with banks and in the economy, inflation and economic growth. The rate is the most important tool in the central bank’s monetary and credit policy. Banks peg their floating interest rates (their income) to the repo rate as it moves in sync with their own interest payout (their expenses) and allows them to manage their financials better.
MCLR or the Marginal Cost of Funds based Lending Rate is a rate fixed by RBI as the minimum interest rate that can be charged by banks on different types of loans. It replaced the erstwhile base rate system for determining interest rates from April 2016.
Now a small point here. The RBI in October 2019 introduced the external benchmarking system that can be used by banks (not Non-Banking Financial Institutions or NBFCs) for some types of loans such as home loans and business loans. This system allows the bank the freedom to peg their floating interest rate with other more current rates such as the Repo Rate, Government of India Treasury Bills or other rates specified by Financial Benchmark India Pvt. Ltd (FBIL). FBIL was set up under RBI initiative in 2014 as an independent benchmark administrator for interest rates and foreign exchange rates.
Most business loans are secured loans which means that the borrower has to offer some type of security to the lender. The property or other asset that you give to the lender as security is known as collateral / collateral security. If the borrower is unable to repay the loan, the lender gets ownership over the asset used as collateral.
#5. Credit Appraisal:
Business loans, big and small, are sanctioned by banks after a careful assessment of the borrower. They try to make sure that they are lending money to a trustworthy applicant. The process of running a background check on the borrower by looking at their credit score, monthly income, assets, debts, etc. to make sure the potential borrower can repay the loan they are asking for is known as credit appraisal.
Once the bank has received complete documents from the borrower and approved the application, they release the funds. This is known as loan disbursement. Depending on terms of the loan, the loan amount may be disbursed to the borrower’s personal account or business account. Loan disbursement may be full or partial, which means all of the principal amount may be released to the borrower or only a part of it may be released. Moratorium and repayment period usually starts after the complete disbursement of the loan.
There is a small but clear distinction for those of you who have taken a line of credit but only withdrawn a small amount. Here you have to understand that the bank has given you complete access to the funds. But you have chosen to withdraw only the amount you need.
#7. Equated Monthly Instalments (EMI):
You may have often heard of this term but not fully understood what it means. Simply put, these are the monthly instalments you pay to the lender each month. But there are some small details you need to understand.
When you get loan approval, three factors help decide how much you have to pay to the lender each month to repay the loan: the principal amount, applicable interest rate and repayment period.
The interest is calculated with these three factors using the compound interest formula. The accrued interest is then added to the principal amount and divided by the repayment period (in months) to deduce the monthly instalments the borrower has to pay to the lender. These are known as Equated Monthly Instalments or simply as EMIs.
In the initial days, the interest component is higher in the EMI versus the principal component. This is because the interest is charged on the whole outstanding amount. But as the principal left to pay slowly decreases with each EMI, the interest component decreases and the principal component increases. This is why the outstanding loan amount looks so high in the first few years and then starts to decrease quickly in the later years.
If a borrower decides to repay their loan before the maturity date of the business loan then it is called foreclosure of the loan. For instance, if a borrower has availed a business loan on 1st September 2020 and its maturity date is 31st August 2023 then if the borrower decided to pay off the principal amount and accrued interest on 28th February 2023, it means they have foreclosed the loan.
While repaying a loan as soon as possible may sound good advice since it may help reduce debt burden, it is not always easy to do so. Some banks do not even allow it for the first few years while others levy a penalty known as foreclosure charge / penalty that the borrower has to pay on top of the principal amount and accrued interest to foreclose the loan.
#9. Lock-in Period:
When you avail a business loan, the lender may have a clause in the loan agreement which states that you must stay with them for a fixed number of years. This is called the lock-in period of a business loan. If you decide to change lenders during the lock-in period, you may have to pay a penalty. After the lock-in period, you can then avail the balance transfer facility and transfer your loan to a different lender, usually without any penalty.
Please note here that these terms may be widely used for other types of loans as well. Understanding them will help you comprehend all loan-related information easily. It will also enable you to make informed decisions.
Now that you have a sound understanding of key terms used for business loans, you may feel ready to look at loan options available in India. You may check our business loans page where we have covered different business loans offered by major Indian banks.