Why you need to think before taking up that loan

There are different reasons why people apply for loans. While personal needs vary, it is always advisable to utilise credit facilities, especially long-term credit, for purchases that will increase in value over time.

There are various forms of credit, which a customer can access through formal channels. These channels include banks, mobile application-based loans (Tala, Branch, okash…), micro finance institutions, savings and credit cooperative societies (Saccos) or informal avenues including small investment groups (chamas).

The credit that banks provide can be short or long term and may include unsecured loans, mortgages and hire purchase loans, or credit facilities such as credit cards, overdraft facilities and letters of credit. In Islamic Banking, credit can be extended via various Islamic finance modes that include various profit and loss (as opposed to interest-based) avenues like Mudarabaha, Musharaka, Diminishing Musharaka and Ijarah.

When extending credit to a customer, a bank will charge a cost known as a loan interest rate that mainly depends on the type of loan and the credit risk profile of the customer.

There are mainly two types of loan interest rates. These are either: Fixed rate-where the interest is negotiated and locked in for either a period or the duration of the loan; as is the case in most of the mobile-based loans and other short-term credit or Variable rate – where the interest rate changes according to the terms and conditions of the loan.

When interest rates in the market change, loans calculated based on fixed rate usually do not get affected, while loans on a variable rate are subject to re-pricing based on the bank’s position and operating costs. As there are different types of loans, banks use different methods to calculate a customer’s loan payment.

These methods typically have the loan on an amortisation schedule (i.e. monthly payments that reduce the debt over time).