September 28 is ‘Ask a stupid question day’. If we are being entirely honest, there’s no such thing as a stupid question — especially when it comes to your hard-earned money. More importantly, when you’re considering applying for a loan, having absolute clarity is essential.

Whether you’re taking a three-year personal loan or a 20-year home loan, taking finance from an external source is a long-term commitment. Arm yourself with the facts and put all those niggling doubts to bed.

Here are five of the most commonly asked questions about loans

How much can I borrow?

How much you can borrow depends on the lender you approach and the type of loan you’re taking.

Typically, each lender or loan provider has its own set of criteria for different types of loans. The more items you are able to check off the list, the better your eligibility is deemed to be. So, your age, income, credit score, current EMIs that you’re paying, nature of your profession, and job stability are all factors that determine how eligible you are. The younger you are, for instance, the more years you have left to work, and so, you’re deemed to be more eligible. Similarly, if you have no current EMIs that you’re paying, you’re a good candidate. Conversely, your eligibility is lower if your income is low, your age is high, your credit score is poor, and if you have existing debts.

The amount you can borrow also depends on whether the loan is secured (backed by collateral) or unsecured. In cases of the former, such as a home loan or a loan against property or securities, you’re pledging an asset as security and receiving a loan in exchange. Since the lender is protected, he can afford to offer you a higher loan amount. However, in case of an unsecured loan, there is no security that the lender has. As a result, to contain the risk, the loan amount is lower.

What if I can’t pay?

Ideally, you must plan how you’re going to repay a loan before you take it. This approach will ensure that you live within your means, and don't over-borrow just because funds are available. But if for whatever reason you are unable to pay the loan, here is how the situation may pan out.

If you anticipate not being able to repay your loan, approach the lender and see if your loan can be restructured. This means checking if the tenor or interest terms can be reworked. This will buy you more time to clear your loan. However, you will have to pay a penalty.

If your loan is secured, and you have pledged an asset such as property, an automobile, gold or securities, failure to repay the loan means that the lender will assume ownership of this asset, and sell it to recover the amount.

You can also opt for a settlement, wherein you negotiate with the lender to pay a portion of the outstanding amount as a full and final settlement of the loan. This isn’t considered to be ‘closing’ the loan, and will affect your credit score. In any case where you’re unable to continue paying your EMIs, your credit score will be impacted. The asset for which you’ve taken the loan may be possessed by the lender. If you’re still unable to repay your dues, your asset is auctioned.

What is a credit score?

Your credit score is a numeric representation of your credit history, which is a record of all your financial transactions. The number, usually ranging from 300 to 900, shows whether or not you’re responsible with credit. The higher the number is, the more creditworthy you are considered to be. Your credit score not only is a snapshot of your financial behaviour, but is also a metric that lenders use to determine your eligibility for a loan. The higher your credit score, the better your eligibility will be. Today, the best loan offers are reserved for persons whose scores are 750 or higher.

Using credit responsibly by clearing your credit card dues and timely repayment of EMIs will further boost this score, whereas actions such as defaulting on payments, or settling your loan instead of closing it will bring it down. In turn, this will affect your ability to borrow credit in any form in the future.

How does a loan save taxes?

The Income Tax Act of 1961 has certain sections that offer tax deductions — a certain portion of the amount paid towards the principal, and/or interest of the loan is free from taxation. The amount that you don’t have to pay tax on varies depending on the loan you have taken, and other parameters as well. For instance, Section 80C offers a deduction of Rs 1.5 lakh towards the repayment of your home loan principal, while Section 24B offers deductions up to Rs 2 lakh on the amount paid towards your home loan interest.

Similarly, Section 80EE offers an additional deduction of Rs 50,000, but only to first-time homeowners.

In certain cases, the tax benefit also depends on how you use funds from the loan. For example, if you use a personal loan for construction purposes, you can claim exemptions under Section 24B. Alternatively, if you use it to buy business assets, you can claim the interest paid as a business expense.

Why do I pay high interest?

It is possible that you don’t meet all the eligibility criteria. For instance, if you have a low credit score or irregular income, even though the financial institution may consider you to be a risky candidate, it may offer funds to you, albeit at a higher interest rate.

If you opt for an unsecured loan, the rate of interest is set higher to give the lender some security. If this is the case, you can offer to pledge collateral to bring down the rate of interest.

Other factors such as the RBI’s monetary policies also have a bearing on loan interest rates. For instance, if the RBI increases the repo rate, which is the rate at which it lends money to banks and other financial institutions, it will cost the financial institution more to avail of funds. As a result, a trickle-down effect means that you will also have to pay a higher rate of interest on a loan.