There are many reasons for which you may have to take a loan. A home loan to buy a home, a vehicle loan to buy a car or a personal loan to meet your needs. A loan doesn’t come free. You need to pay the interest as well as repay the principal over a period of time.
A default on the loan repayment can hurt your credit score in addition to the penal interest. While the credit score is an indicator of your creditworthiness, the cash flows is an indicator of your financial position.
What is a Credit Score
It is a 3digit number between 300 and 900 assigned by CIBIL based on your credit history. A detailed account of your loans, repayments, credit card bills in the past is scrutinised before the credit score is assigned to you. A high credit score (750+) is an indicator of good creditworthiness and classifies you as a safe borrower.
However, the credit score is not constant. Any default on repayments, or bill payments can pull down your credit score. Hence, it’s best to check your credit score before applying for a loan.
What is cash flow analysis
A cash flow statement is a summary of all your cash inflows and outflows over a particular period of time. A surplus is an indicator that you have funds on hand to service the loan repayment. On the other hand, a deficit implies that you do not have the loan repayment capacity.
So, a cash flow analysis will help to know if you can service the loan. Lenders also would be ready to offer a loan to an individual who enjoys a surplus, as it is an indicator of the repayment capacity.
How does cash flow analysis help to tag a loan as good or bad?
Loan is an outflow, since you’ve to repay the loan from your earnings (cash inflow). But, there are some loans, like a home loan that offer you a tax advantage. To the extent of the tax advantage, there is an effective reduction in the interest rate. This saving translates to a reduced outflow or can be considered as notional income.
Similarly, a loan taken for an appreciating asset can be termed as a good loan. On the other hand, if a loan entails only outflows, it can be termed a bad loan.
Say you’re taking a personal loan and deploy the funds in the equity market, which is in a bullish phase. If you make a sizeable profit which exceeds the cost of the personal loan, then such a loan can be tagged as a good loan. Thus, cash flow analysis helps to check whether a loan is good or bad.
To conclude, before applying for any loan, check your credit score to check your eligibility. Also do a cash flow analysis to determine if the loan is good.