Chapter 3 · Question 4
What are terms of credit?
Answer
Direct Answer
Terms of credit include the interest rate, collateral, documentation, mode of repayment, and loan duration. These terms decide how costly or accessible a loan is for the borrower. Poor borrowers often face difficulty because they lack collateral or formal documents.
Simple Explanation
Terms of credit are the conditions attached to a loan: the interest rate, collateral (asset pledged as security), required paperwork, repayment method, and loan duration. These decide how expensive and accessible credit is.
Exam-Ready Structure
Every loan agreement specifies certain terms (conditions) that the borrower must accept. These are called the terms of credit:
• Interest rate: The cost of borrowing, expressed as a percentage of the principal. Higher interest rates mean costlier credit. Formal sector loans (banks) usually have lower interest rates; informal lenders (moneylenders) often charge very high rates.
• Collateral (security): An asset that the borrower pledges to the lender as a guarantee. If the borrower fails to repay, the lender can sell the collateral to recover the loan. Common forms of collateral: land titles, house property, livestock, bank deposits, or standing crops. The requirement for collateral is a major obstacle for poor people who often own no assets worth pledging.
• Documentation: Banks and formal lenders require written records — identity proof, address proof, income proof, land records — before giving a loan. Poor, illiterate borrowers may struggle with this paperwork, pushing them toward informal lenders.
• Mode of repayment: How the loan will be repaid — in monthly instalments, at the end of a season (for crop loans), or through labour services (common in informal lending, such as bonded labour arrangements).
• Duration of the loan: Short-term, medium-term, or long-term. Crop loans are often short-term (one season); home loans are long-term (10-20 years).
The terms of credit determine:
• How costly the credit is for the borrower.
• How much risk the lender faces.
• Whether the credit trap (borrowing more to repay old debt) is likely.
The poor face unfavourable terms — high interest, onerous collateral demands, and harsh repayment conditions — which is why expanding access to formal, low-cost credit is a major policy priority.
Key Points
- Terms of credit include the interest rate, collateral, documentation, mode of repayment, and loan duration.
- These terms decide how costly or accessible a loan is for the borrower.
- Poor borrowers often face difficulty because they lack collateral or formal documents.