Terms of Credit – Long Answer Questions (Money and Credit)
Medium Level (Application & Explanation)
Q1. Explain the four main components of the terms of credit with suitable examples.
Answer:
The four components are interest rate, collateral, documentation, and repayment schedule.
The interest rate is the extra amount paid over the principal. Example: a bank may charge 10% per annum.
Collateral is an asset kept as security. Example: land papers for a tractor loan, or gold for a small loan.
Documentation means legal papers like Aadhaar, PAN, bank statements, and proof of asset ownership.
The repayment schedule tells when and how to repay. Example: EMI every month for 5 years.
These terms decide the cost, risk, and access to a loan for different people.
Q2. Why does the interest rate matter so much for borrowers? Explain with examples.
Answer:
The interest rate is the cost of borrowing. A high rate makes the loan very expensive.
A bank may lend at 9–10% per year. This is usually affordable for steady income earners.
A moneylender may charge 5% per month (60% per year). This is very costly.
Example: Ramu borrows ₹10,000 at 5% per month. He pays ₹500 interest every month. In one year, that is ₹6,000.
A lower rate helps people repay on time and avoid the debt cycle.
A higher rate can trap borrowers, as interest keeps adding and repayment becomes hard.
Q3. What is collateral? How does it affect lenders and borrowers differently?
Answer:
Collateral is an asset given as security for the loan. It reduces risk for the lender.
If the borrower fails to repay, the lender can sell the collateral to recover money.
Examples: land, house papers, gold, cattle, or even crops in rural areas.
For the lender, collateral provides safety and assurance.
For the poor, lack of assets means they cannot get loans from formal sources like banks.
Thus collateral protects lenders, but it excludes many poor borrowers from cheap credit.
Q4. Explain the role of documentation in loan agreements. Why can it be a barrier sometimes?
Answer:
Documentation confirms the borrower’s identity, address, income, and ownership of collateral.
It makes the loan legal, clear, and binding for both sides.
Banks ask for Aadhaar, PAN, photos, salary slips, bank statements, and collateral papers.
Informal lenders may not ask for documents. They rely on personal trust or verbal promises.
Strict documents help banks reduce fraud and risk. But they can block people who lack IDs or proofs.
So documentation gives safety, but it can also limit access to formal loans for the poor.
Q5. What is a repayment schedule? How does it help both borrowers and lenders?
Answer:
A repayment schedule tells the timing, amount, and method of paying back the loan.
Example: EMIs are fixed monthly payments for a set number of years.
It helps the lender plan cash flow and ensure regular recovery.
It helps the borrower budget income and avoid sudden large payments.
Some lenders ask for lump sum repayment or after harvest in rural areas.
A clear schedule reduces confusion, defaults, and stress for both sides.
High Complexity (Analysis & Scenario-Based)
Q6. A shopkeeper can borrow ₹5,000 from a moneylender at 5% per month (no documents), or from a bank at 12% per year (needs documents and collateral). Which is better and why?
Answer:
The moneylender is faster and needs no documents. But the interest is 60% per year, which is very high.
The bank is slower and needs collateral and papers. But the rate is 12% per year, which is much lower.
On ₹5,000 for one year, the moneylender may take about ₹3,000 interest. The bank would take about ₹600.
If the shopkeeper has documents and some asset, the bank is safer and cheaper.
If he lacks papers, an SHG or microfinance could be a middle path with lower rates than a moneylender.
So the bank is better for cost and safety. The moneylender only wins on speed and ease.
Q7. A farmer pledged his land as collateral for a bank loan. A drought hits, and he cannot repay on time. Analyze the risks and suggest fair solutions in the terms of credit.
Answer:
The farmer faces income shock due to drought. Default risk rises.
The bank can legally act on the collateral. But this can cause distress and loss of livelihood.
Rigid terms may push the farmer into a debt cycle with other costly loans.
Fair solutions: extend the repayment schedule, give a moratorium period, or reschedule EMIs.
Reduce or waive penal interest, and use crop insurance payouts to cover dues.
This keeps the bank’s safety and protects the farmer’s dignity and future income.
Q8. Sita wants ₹2,000 to buy sewing material. She has no collateral or payslips. Compare borrowing from an SHG at 2% per month versus a moneylender at 5% per month.
Answer:
Sita lacks collateral and documents. A bank loan is hard for her.
An SHG charges 2% per month and uses social collateral. It also allows weekly or monthly repayments.
A moneylender charges 5% per month and may demand gold or household items as security.
SHG interest is lower, so total cost is less. Repayment is more flexible and supportive.
SHGs also build savings habits, credit history, and community trust.
So, SHG credit is more inclusive, affordable, and safe for Sita’s needs.
Q9. Design suitable terms of credit for a seasonal small shop that earns mostly during festivals. Justify each term.
Answer:
Interest rate: Moderate and fixed, so the owner can plan costs without surprises.
Collateral: Small or no collateral if loan is small; maybe stock or receipts as security.
Documentation: Basic KYC only, so access is easy but still legal and safe.
Repayment schedule: Flexible with lower EMIs off-season and higher EMIs during festivals.
Add a short moratorium before the season begins, so funds can be used to buy stock.
These terms match cash flows, reduce default risk, and prevent a debt trap.
Q10. Two loans of ₹10,000: Loan A is from a bank at 10% per year with monthly EMIs. Loan B is from a moneylender at 5% per month, lump-sum after a year. Compare total cost and stress level.
Answer:
Loan A cost (simple view): about ₹1,000 interest for one year, and paid in EMIs. Actual EMI reduces interest over time.
Loan B cost: 5% per month = 60% per year. Interest about ₹6,000 for one year, paid in lump sum.
Loan A spreads payments, so budgeting is easier. Lower chance of default.
Loan B needs one big payment, which creates stress and risk if income is irregular.
Loan A requires documents and maybe collateral, but it is cheaper and more stable.
Loan B is fast but very expensive and can cause a debt cycle if you fail to repay.
