How loans work- A guide for school students

In our day to day lives, we see around us, that most people use money they do not presently have with them, to pay for things they want. In simple terms, this money that they seem to have borrowed is loan. In today’s modern world, it has become important for adults, and students alike, to understand how loans actually operate. I am writing this blog to explain in easy language what loans are, how they work and what one should bear in mind when thinking of taking loans. I hope this blog will help you all make wiser financial decisions.

Definition of loan and its types

To put it simply, loan is the money that a person, company or government borrows from another person or a financial institution (like a bank) with the promise to repay it at a later date. However, loans are not free of cost. Loan has to be paid back with some extra money, which is called an interest. You can consider it like a fee you must pay for borrowing the money. Let me give you a simple example. If someone wishes to purchase a cycle that costs Rs 2000, but she has only Rs 1000 at that point of time. A friend offers to lend her Rs 1000, on the promise that she has to repay Rs 1100 after a month. In this case then, the extra Rs 100 is the interest, and it is the cost or fee of borrowing the money.

There are multiple reasons why people may borrow money. It could be borrowed as:

• Student loans to help students pay for college or university.

• Home loans (Mortgages) to help people buy houses.

• Car loans to help people buy vehicles.

• Personal loans to help pay for things like medical bills, weddings, or emergencies.

• Business loans to help businesses grow or start.

As you can see, loans are urgent as sometimes, people do not have enough saved money to meet the requirement that has arisen. However, it is extremely important to use loans wisely and only when you actually need them.

Working of loans

Now let us see how do loans work on ground. There are some terms we must understand:

1. Principal: This is the original amount of money you initially borrow. If you take a loan of Rs 1,000, then that amount is your principal.

2. Interest: This is the fee/cost you pay for borrowing money. It is usually shown as a percentage of the principal, known as the interest rate. For example, a 5% annual interest rate on a Rs 1,000 loan means you pay Rs 50 each year as interest.

3. Term: This is the length of time you agree to repay the loan. It could be a few months or many years, depending on the type of loan.

4. Collateral: This is something valuable we promise to give, if we cannot repay the loan in time.

Interest is of two main types:

• Simple interest: This is calculated only on the principal.
  Example: Rs 1,000 loan at 5% simple interest for 3 years = Rs 1,000 + (3 x Rs 50) = Rs 1,150 total repayment.

• Compound interest: This is calculated on the principal and any interest already added.
  Example: If you owe Rs 1,000 and interest is compounded yearly at 5%, you will owe more than Rs 1,150 after 3 years because each year’s interest is added to the balance before calculating the next year’s interest.

As can be seen form the very definitions above, compound interest can grow fast, so one has to be very careful about appreciating the pros and cons when taking money on loan.

Meaning of a credit score

You would have heard of the term “credit score" many a times. Banks and other lending institutions look at credit scores of a person before giving a loan out to her or him. Credit score shows the level of trust that can be put in a person. A high credit score means the person has a history of repaying loans on time, so the bank would like to lend money to such a person at lower interest rates as it knows that the person will pay back. As a student, you might not have a credit score yet, but when you become an adult, your financial habits, like paying bills on time, can affect your credit. It is always good to repay somebody’s borrowed money in time!

Importance of borrowing responsibly

As you can see, borrowing money is something we must do sensibly as grow up. Failure to repay money can make our credit score go down which can create problems for us when we try taking other loans or increase the interest rates that banks charge us. It must always be remembered that one must borrow only when we have a solid plan to pay back in time, with interest. Owing money can cause stress and affect mental health if not managed well.

Even though you may not be taking out loans yet, here are some smart borrowing habits to remember:

1. Borrow only what you need. Do not take extra money just because it is available.

2. Understand the interest rate. Know how much the loan will cost over time.

3. Make a repayment plan. Always have a plan to pay back your loan on time.

4. Compare lenders. Remember that some lenders offer better interest rates and terms than others.

5. Ask questions. If you do not understand something, ask a trusted adult, teacher, or financial advisor.

Loans can be helpful tools when used with caution as they allow people to buy urgent things that might otherwise be impossible. But loans also come with responsibilities. Understanding how loans work, what interest is, how long you have to repay, and what risks are involved, is the key to using them properly.

As a student, learning about financial topics like loans will prepare you for real-life situations. Whether you want to go to college, buy your first car, or start a business someday, knowing how borrowing works can help you make smart and confident choices. Always remember that borrowing money is not bad, but borrowing without understanding is. So, start building your financial knowledge right now, and you will be geared up for making smart decisions in the future.