A gold loan is a secured loan in which the borrower keeps their gold, ranging from 18K to 24K, with a bank or financial institution as collateral and has capital against it. In comparative terms, a gold loan can be understood as a concept similar to a “mortgage loan” in which the owner keeps his house or property as a mortgage with the bank and takes out a loan against the bank for meet its capital needs.
How do gold loans work?
A gold loan is among the profitable loans of banks because banks do not care about non-performing assets (NPAs). Indeed, the jewelry taken as collateral remains with the bank even if the borrower is in default of payment of his monthly payments (EMI) on his loan.
The operation of a gold loan is:
- Quality check: When a client approaches a financial institution for a gold loan, the first step the institution takes is to verify the purity of the gold jewelry that is considered collateral as well as determining the value of the jewelry. .
- Know Your Customer (KYC): Knowing the standards and checks of your clients as set out by the Reserve Bank of India (RBI) are carried out by the bank, where the bank gets to know their client’s details such as identity, credit history, the need to apply for a loan and other crucial details in granting the loan.
- Gold Loan Approval: Once the quality and value of the jewelry is determined and the KYC procedure is complete, the terms of the loan are agreed upon by both the financial institution and the consumer. After agreement, the loan is approved and the amount is then credited to the borrower’s account. This whole process can be completed in a matter of hours.
What are the characteristics of a gold loan?
The interest rates on gold loans vary depending on the purity of the gold. The higher the purity of the gold, the higher the amount that can be used. Interest rates range from 8% per year to 18% per year in the public sector, while in the private sector these rates can reach 24% per year.
Haircut and loan-to-value ratio (LTV)
According to RBI guidelines, banks can grant a maximum of 90% of the value of gold in the form of a loan, which implies a minimum of 10% in the form of a haircut. Typically, the actual loan-to-value ratio ranges from 55% to 65%, or around 35% to 45% for banks, making it the safest loan for banks.
The loan-to-value ratio or LTV ration means the amount a customer will get relative to the value of gold. For example, if the value of the jewelry is INR 10,000 and the LTV is 65%, the maximum loan amount the customer can get would be INR 6,500.
A gold loan is generally a short or medium term loan, with terms ranging from six months to 24 months. It is therefore not a long-term loan instrument.
Loan available even for low credit scores
As the jewelry will be deposited with the bank as collateral for the loan, the bank is confident to sanction a loan to the person even with a low credit rating.
The weight of the stones and their value are not counted
Even though gemstones have a high value, they are not taken into account when calculating for a gold loan. Only the value of gold is taken into account for the calculation, which is why a digital gold product is often preferred over a regular product for the purpose of pledging.
Who should opt for a gold loan?
Those who need short-term funds
The gold loan works like a working capital loan that is common in businesses that meet short-term fund requirements. In such scenarios, a gold loan is preferred over a personal loan with unfavorable interest rates on a comparative basis.
Those with a low credit score
As the jewelry serves as collateral against the loan, the bank is comfortable advancing a gold loan even to a person with a low credit rating.
Those who have gold but take out a personal loan
People who are considering a short-term personal loan and have unused gold in lockers should consider taking out a gold loan instead of a personal loan in order to save on interest charges.
Those who opt for a gold loan from the unorganized sector
Users consider opting for a gold loan from unorganized players for fear of being rejected by organized financial institutions that might not provide them with a loan due to their credit history. These users end up paying high interest rates of up to 25% to 50% per year.
Opting for a gold loan from banks and other organized players is a better option as credit history is not a factor that impacts the loan since a gold loan is completely secure. This would help save interest charges, as banks are required to charge interest in accordance with RBI standards, which are in line with the market and not exorbitantly.
How to opt for a loan with Digital Gold?
With the introduction of digital gold products, people now have access to a more lucrative option to reduce the overall interest charge on gold loans.
You might consider liquidating your physical pure gold (available as ‘vedhnis’, cookies, coins, and bullion) and converting the money to cash in the form of Digital Gold Sovereign Bonds (SGBs). This would help you in two ways: the first to secure the necessary funds and the second to earn interest income of 2.5% per annum on the face value even during the term of the loan, thus reducing the overall cost of credit. For example, SBI’s interest rate for a loan against SGB is 9.25%, but since the underlying is an SGB, the effective cost would be 6.75% per annum.
The tax benefits associated with using the gold loan for specific reasons include:
- Buying or improving a house: Tax benefits can be obtained under Articles 24 (b) and 80C of the Income Tax Act, which allow exemption of the eligible part of interest expense and repayment of principal respectively, thereby reducing the cost overall credit.
- Cost of commercial interests: Interest charges on a gold loan taken out for business purposes can be claimed when filing tax returns as a business expense, saving on your tax liability.
Gold loans, in general, serve as a source of support when you are in urgent need of capital. You must not only understand these products in order to meet future needs, but also understand the upcoming new variations which are more secure and effectively reduce the overall interest charge on the loan.