Bank Loan Default
About - Bank Loan
A bank loan is a sum of money borrowed from a bank or financial institution for a specified period, typically with the agreement to repay the loan amount and interest over time. This is one of the sources of income for the banks to provide loans and levy interest on that amount.
It is a financial arrangement where the borrower receives funds from the bank. In return, the borrower agrees to repay the borrowed amount, often in installments, over an agreed-upon period.
Bank loans are a fundamental financial tool that individuals and businesses rely on to achieve their financial goals. Whether you’re looking to buy a new home, start a business, or purchase a vehicle, understanding the world of bank loans is crucial.
Bank loans play a crucial role in the economy by providing the borrowers the advantage of obtaining a lump sum of money upfront, which they can use for their intended purposes, while agreeing to repay the loan over time, making it more manageable and convenient.
However, it’s essential for borrowers to carefully consider the terms and conditions of the loan, including interest rates, fees, and the overall cost of borrowing, to ensure that it aligns with their financial goals and capacity to repay.
Bank Loan Terms
For a better understanding of bank loan default, let us first focus on the banking terms.
Principal Amount: This is the initial amount borrowed, also known as the loan principal. It’s the sum of money that the borrower receives from the bank.
Interest: The bank charges interest on the loan, which is the cost of borrowing. Interest rates can be fixed (remaining constant throughout the loan term) or variable (changing with market conditions).
Loan Term: The loan term specifies the duration over which the borrower is required to repay the loan. Loan terms can vary widely, ranging from short-term loans (e.g., a few months) to long-term loans (e.g., 30 years for a mortgage).
Repayment Schedule: Borrowers typically repay bank loans in regular installments, which include both principal and interest payments. The schedule may vary depending on the type of loan and the terms agreed upon.
Secured or Unsecured: Bank loans can be either secured or unsecured. Secured loans require collateral, such as a home or a car, which the bank can claim if the borrower fails to repay. Unsecured loans, on the other hand, do not require collateral but often have higher interest rates.
Purpose: Bank loans can be used for a wide range of purposes, including buying a home (mortgage loan), purchasing a vehicle (auto loan), funding a business (business loan), covering personal expenses (personal loan), or financing education (student loan).
Creditworthiness: Borrowers’ eligibility for a bank loan and the interest rate they receive often depend on their creditworthiness, including factors such as their credit score, income, employment history, and financial stability.
Secured and Unsecured Loans
To understand loans provided by banks, we need to understand the potential risk for the bank in case of a default. Secured and unsecured loans are two distinct types of financial arrangements, and they differ primarily in terms of collateral, risk, and interest rates.
Secured Loans
Collateral Requirement: Secured loans are backed by collateral, which is an asset that the borrower pledges to the lender as security for the loan. If the borrower fails to repay the loan as agreed, the lender has the right to seize and sell the collateral to recover the outstanding debt.
Common types of collateral for secured loans include real estate (as in the case of mortgage loans), automobiles (for auto loans), business assets, and valuable personal property.
Risk and Interest Rates: Secured loans are generally considered less risky for lenders because they have a way to recover their money through the collateral. As a result, secured loans typically come with lower interest rates compared to unsecured loans.
Loan Amount: The amount you can borrow with a secured loan often depends on the value of the collateral. Lenders may offer higher loan amounts if the collateral has substantial value.
Unsecured Loans
Collateral Requirement: Unsecured loans do not require collateral. Borrowers obtain these loans solely based on their creditworthiness, income, and the lender’s assessment of their ability to repay.
Risk and Interest Rates: Unsecured loans are generally considered riskier for lenders because they lack collateral. To compensate for this risk, lenders typically charge higher interest rates for unsecured loans compared to secured loans.
Loan Amount: The loan amount for unsecured loans is typically determined by factors like the borrower’s credit score, income, and repayment capacity. These loans tend to be smaller in size compared to secured loans.
Use Cases: Unsecured loans are often used for various personal expenses, such as medical bills, debt consolidation, vacations, and other short-term financial needs. Credit cards and personal loans are common examples of unsecured credit.
Good CIBIL Score
A CIBIL score, also known as a credit score, is a numerical representation of an individual’s creditworthiness. It is a three-digit number that ranges from 300 to 900 in India and is calculated based on the individual’s credit history, including their past borrowing and repayment behaviour.
The CIBIL score is named after the Credit Information Bureau (India) Limited, which is one of the leading credit bureaus in India responsible for collecting and maintaining credit-related information on individuals and businesses.
Understanding the CIBIL Score
Credit History Analysis: The CIBIL score is derived from a person’s credit report, which includes information about their credit accounts, such as loans and credit cards, and their repayment history. It also takes into account factors like the total credit available, outstanding debt, and the length of credit history.
Three-Digit Range: CIBIL scores typically fall within a range of 300 to 900. A higher score indicates better creditworthiness and a lower risk for lenders, while a lower score suggests a higher credit risk.
Credit Risk Assessment: Lenders, including banks, financial institutions, and credit card companies, use CIBIL scores as an important factor in evaluating the credit risk of potential borrowers. A high CIBIL score increases the likelihood of loan approval and may result in more favourable terms, such as lower interest rates.
Factors Impacting CIBIL Score
Payment History: Timely repayment of loans and credit card bills has a significant positive impact on the score.
Credit Utilization: The percentage of available credit that a person is currently using can affect the score. High credit card balances relative to the credit limit can negatively impact the score.
Length of Credit History: A longer credit history often leads to a higher score, assuming a positive repayment history.
Loan Feasibility
A loan from the bank should only be taken if and only if you are sure to repay the entire loan amount. Not complying with the bank policies could have an adverse effect on any future loans.
Whether taking a bank loan is justified depends on your individual financial situation, goals, and the purpose for which you are borrowing. Bank loans can be a valuable financial tool when used responsibly and for the right reasons.
Taking a bank loan can be justified when it is used for a well-defined purpose that aligns with your financial goals, you can comfortably afford the loan payments, and you have explored alternative funding options.
Factors to be considered before taking a loan
Purpose of the Loan: Consider why you need the loan. Is it for a necessary and well-thought-out purpose, such as buying a home, starting or expanding a business, or investing in education? Loans used for investments that can potentially generate returns, like a mortgage for a home or a business expansion loan, can be justified if they align with your long-term financial goals.
Affordability: Assess your ability to repay the loan. Carefully review your current income, expenses, and financial stability to ensure that you can comfortably make the required loan payments. A loan is justified when you can meet the repayment obligations without causing financial strain.
Interest Rates and Fees: Examine the interest rate and any associated fees or charges. Lower interest rates make a loan more cost-effective, while high fees can increase the overall cost of borrowing. Compare loan offers from different lenders to find the most favourable terms.
Alternatives: Consider whether there are alternative funding options that might be more suitable for your needs. For example, if you’re financing a small project or expense, you might explore alternatives like saving up or using a credit card (if you can pay it off in full each month) before opting for a loan.
Risk Management: Evaluate the potential risks associated with the loan. In the case of secured loans, be aware that your collateral may be at risk if you cannot repay the loan. Assess your risk tolerance and have a backup plan in case of unexpected financial setbacks.
Long-Term Impact: Think about the long-term consequences of taking a loan. How will it affect your financial situation in the years to come? Will it help you achieve your goals or potentially hinder your financial progress?
Bank Loan Default
This is very important to realize that a loan from a bank has some major consequences if you do not comply with the rules of the bank. The golden rule of taking a loan from the bank is to pay and keep paying all your installments in time. Try not to default on any loan taken from the bank.
The bank always has a tie-up with a company that acts as a recovery agent for the bank. When a loan is defaulted the recovery agent knocks at the door of the borrower and asks them to repay the loan. Over a period of time, this issue becomes serious and the borrower feels his reputation in the society is at stake.
Let us consider a case where a farmer has taken a loan from the bank for planting crops for a period of one year. After the completion of one year farmer was not able to repay his instalment to the bank may be due to unproductive crops. In such cases as farmer bank waits and tries to give them ample time.
Let us suppose that even after the second year the farmer had not paid his installment either intentionally or due to lack of funds. The recovery agents start visiting the house of the farmer frequently to urge him to repay his dues.
If the farmer is in no position to pay back his dues even after the grace period, the bank then files a case against the farmer in court for non-performing assets and calls the farmer for a settlement.
Settlement is the process where the bank and the farmer negotiate an amicable amount that suits both parties. It needs to be mentioned that the CIBIL score of the person takes a hit when the bank calls for settlement. A decrease in CIBIL score means that getting future loans for the person is going to be tough. Hence it is advisable to repay all the bank dues in time always without undergoing settlement.
Let us consider the case of a gold loan. Gold loans come under a secured loan category where the person is taking a loan in lieu of gold. In the case of a gold loan bank always gives a loan of 70-75% of the total value of the gold.
Let us assume that the person has taken a gold loan and after the elapse of the loan duration the person has not paid his amount. In such cases, the bank sends a letter to the person informing the due amount and waits for a period of 90 days for the person to deposit the amount.
RBI guidelines state that a bank can auction the deposited gold after a period of 90 days. Now gold has an emotional value attached, hence bank does not auction the gold immediately after 90 days but waits for another fixed period and sends a letter to the defaulter.
If a bank wants to keep its book clean then it may take the decision to auction the gold. But they wait for some more time because it may hit its reputation. If a person returns his dues after the bank auctions the gold, then the bank will not be able to give him the deposited gold back and the person can bring a bad reputation to the bank which can hamper its credibility.
After sufficient time and repeated letters and recovery agent visits, if the bank does not get their due amount, then they auction the gold. The total amount due is recovered by the bank and the remaining excess amount is sent to the person by a demand draft.
Let us consider the case of a vehicle loan. A person taking a car loan from a bank has to mention Hypothecation to a bank in the Registration Certificate (RC). This means the vehicle is mortgaged to the bank, and as the person pays the full amount, the bank provides a ‘No Objection Certificate’ (NOC), and the RC is updated by the person as the vehicle has become his own now.
If the person is not able to pay back the loan after a due period, the recovery agents start visiting the person’s house. If the person still ignores paying the dues, the bank is liable to take back the vehicle. The bank can then auction the vehicle, and recover its pending due amount. This hits the CIBIL score of the person.
The bank does not falter in the recovery of home loans. Home loans are capital-intensive and span over a large period. The banks are particularly vigilant about home loan recovery.
When a person takes a home loan from the bank, the bank keeps the mortgage papers. This makes the bank the owner of the house and the bank returns the papers when all the instalment dues are mitigated.
As residence does is not a depreciating asset hence bank does not go for settlement with the defaulter. Once the person has defaulted and after sending many letters the person is not paying back the dues, the bank files a strong case against the person in court.
In case of settlements, the bank sometimes waives the interest and asks the person to pay back the principal amount. But in the case of home loans, the bank does not go for a settlement of the loan.
The bank then auctions the residence according to the market price. The highest bidder buys the property by paying the bidding amount to the bank. The bank recovers the due amount and interest within the stipulated period and sends the remaining amount to the defaulter person through a demand draft. The CIBIL score of the person takes a severe blow in such a case.
Personal loans are unsecured loans. Hence these loans are given at a very high rate of interest because chances of default are high. These loans are provided based on the trust and CIBIL score. The rate of interest varies based on the credibility score of the person.
In case the person fails to repay his loan after the due period, the bank goes for settlement with the person. Settlement takes place over a period of time after repeated intimation and sending recovery agent visits. This takes a drastic CIBIL score hit and the person would not be able to take a loan from any other bank.
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