The Finance Nest

Case Study

India faces a significant financial literacy gap: only about 27% of adults are considered financially literate, far below the 52% seen in advanced economies. Many borrowers from all strata — students seeking education loans, families taking home loans, and consumers relying on EMIs or digital credit — lack basic knowledge of loan terms. They often misunderstand interest calculations, EMI burdens, and hidden costs. This case examines systemic issues behind these knowledge gaps. Using composite examples across education loans, housing loans, EMIs and digital lending, it highlights how poor borrower awareness leads to over-indebtedness, rising defaults and non-performing assets (NPAs). Questions invite discussion of interventions (e.g. borrower education, product design, regulatory measures) to mitigate these problems.

Retails loans in India are having a good share in banking sector. From merely 6.1% in March 1990 it has jumped to 21.6 % by 2019. However India faces a significant financial knowledge gap in terms of retail banking. As per the study of Weforum only about 27% of Indian customers, who avail loan, are considered to be financially literate. Many borrowers from all strata — students seeking education loans, families taking home loans, and consumers relying on EMIs or digital credit — lack basic knowledge of loan terms. They often misunderstand interest calculations, EMI burdens, and hidden costs. In this case we are going to discuss the impact of these knowledge gap and instruments to overcome those. Using composite examples across education loans, housing loans, EMIs and digital lending, it highlights how poor borrower awareness leads to over-indebtedness, rising defaults and non-performing assets (NPAs).

Case Body

The Indian credit system has expanded rapidly in past, however many borrowers remain ill-equipped to navigate through it. This deficit resulted in poor decision-making and vulnerability to debt traps. In practice, prospective borrowers often sign loan agreements without fully understanding the terms.

Pre-Disbursement Illiteracy

A common scene unfolds at a bank branch: a worried father clutching a student loan sanction letter, believing it entitles him to immediate funding. In reality, he had already paid his daughter’s tuition fees out of pocket and expecting the bank to reimburse those costs. When the loan sanctioned, he discovered to his surprise that the bank can not refund his earlier payments which he paid already to the college. He realized too late that the sanction letter was not the end of the story. In fact, banks warn that a sanction letter is valid for only six months and requires a formal disbursement request within that period. Many borrowers misunderstand these mechanics, treating the sanction like a cash voucher.

Similarly, new housing loan customers often misread sanction terms. For example, a middle-class family got a home loan sanctioned for construction of new house. Due to some personal reason they did not started the construction of the home soon without realizing that the bank would charge heavy interest if construction not started in time. They were caught off-guard when the lender insisted that the borrowers must complete the construction of the house soon or there would be higher interest rate. Banks typically require borrowers to utilize the housing loan funds within 1-2 year and complete the construction in same period. In this case, the family had no idea that they need to pay a higher interest rate. In short, the loan was “sanctioned” on paper with lower interest rate, but as there was no construction going on it converted to a clean loan interest rate.

These examples highlight a pattern: borrowers often misconstrue conditional approvals as guarantees of immediate funds. They neglect to follow up on required steps (like submitting final documents or raising a disbursement request) and may misuse their own money in anticipation. A former banker notes that “many students live under the misconception that getting the loan approved and a sanction letter is the final stage of the education loan process”. In practice, a simple loan is a complete process of application, sanction, disbursal, EMI and only end with the final payment of loan. Even after sanction, lenders conduct further checks (legal/title verification for mortgages, income proof, etc.) before releasing funds. This gap in understanding can leave borrowers scrambling and sometimes dropping out of studies or projects when the funding does not materialize as expected.

Post-Disbursement Misunderstanding

Once the funds are disbursed to customer, a different set of pitfalls emerges. Borrowers with limited financial literacy often fail to grasp the strict repayment terms, leads to very costly consequences. Consider a new home loan customer who is a salaried professional who dutifully paid his EMIs on time for a year. After a year due to cash crunch, he skipped one month’s EMI, thinking the bank would quietly allow it. Instead, the bank automatically retried the debit mandate multiple times. Each bounced attempt incurred an ECS penalty fee, and late-payment interest piled on. Unaware that even a single missed EMI can damage credit, he was shocked to receive notices about delinquencies.

In similar way an education loan customer defaulted in his EMI payment for 6 months which resulted in loan account being classified as NPA. As soon as he got the new job he planned to start the EMI payment and regularize the NPA account. He believed mearly starting the EMI payment would regularize his education loan. What he was not aware of was the fact that now he need to clear all the previous dues + penalty + charges along with latest EMIs to regularize his loan. This put him in a situation where even if he want to pay the EMI, his account would never be out of NPA.

In one case, a borrower in Kerala paid ₹6,500 in bounce charges after his lender attempted to collect a missed EMI eleven times in single month. Each unsuccessful attempt generated an extra fee. The borrower had not realized that relying on automated debits meant that a single insufficient balance could multiply into large penalties.

The cumulative effect of these misunderstandings is severe. Without financial buffers (75% of Indians lack any emergency fund), borrowers under stress may “skip the EMI” one month, setting off this domino. The result: a once-manageable loan can quickly turn into an NPA due to technicalities, and a credit score can plummet from a single oversight. As one digital-finance expert warned, each EMI failure not only adds penalty interest but “reflected negatively in the borrower’s repayment record”. Over time, ill-informed borrowers find themselves in a debt trap of high penalties and barred access to further credit.

Compelling Questions

1. Pre-Disbursement Risks: In the student loan example, what misunderstandings did the borrower have, and how did those affect the outcome? Who is at fault, and how could the bank have helped clarify the situation?
2. Post-Disbursement Consequences: For the home loan client who missed an EMI, trace how one missed payment led to severe penalties. What regulatory norms (e.g. RBI’s NPA definition) played a role, and why might the borrower not have anticipated these?
3. Role of Credit Scores: Discuss why ignorance of credit scores is risky, using the digital loan borrower example. What steps could lenders or regulators take to improve borrowers’ awareness of credit reporting?
4. Preventive Measures: As a former banker, what practical steps would you recommend to borrowers before and after loan sanction to avoid these pitfalls? For example, how might banks improve borrower education during loan origination?
5. Financial Literacy Solutions: Evaluate interventions (by banks, fintech apps, or regulators) that could reduce borrower illiteracy. How effective are financial-literacy workshops, loan counseling, or smartphone apps in addressing these issues?

Teaching Note

• Key Issues: This case highlights how limited financial understanding can sabotage even well-intentioned borrowers. Before disbursal, confusion over the sanction letter’s validity and disbursement conditions (e.g. needing margin money or document checks) can delay or negate the loan’s usefulness. After disbursal, ignorance of repayment rules – such as when a loan becomes NPA (90 days overdue), the impact of ECS bounce fees, and credit-score reporting – can quickly spiral borrowers into deeper trouble.
• Learning Objectives: Students should recognize that borrower behavior is shaped by understanding (or misunderstanding) of loan terms. They should analyze both lender and borrower responsibilities: how much should a bank explain terms versus the borrower’s duty to ask? They should also connect classroom concepts (like NPA rules and credit scoring) to real-life examples.
• Discussion Guidance: The questions steer discussion from concrete examples to broader lessons. For Q1, students should identify the specific misconceptions (e.g. sanction letter vs disbursal) and brainstorm solutions like clearer borrower communication or follow-up processes. Q2 invites analysis of RBI rules and the cumulative effect of penalties, reinforcing that delaying an EMI can lead to NPA classification. Q3 encourages debating credit literacy: citing data (45% haven’t checked scores) and discussing remedies like mandatory credit-report disclosures. Q4 and Q5 push students to propose actionable remedies: e.g., role-play a banker explaining terms, designing user-friendly loan documents, or suggesting fintech tools for reminders.
• Teaching Points: Emphasize the “banker’s perspective”: lenders often face predictable defaults due to these knowledge gaps. Stress the importance of simplicity in communication (using local language, visual aids, or examples) and of financial counseling at branches. Discuss regulatory aspects: RBI and SEBI have guidelines on disclosures, but enforcement and borrower comprehension remain challenges. Encourage debate on ethics – should banks proactively ensure understanding or is it solely the borrower’s responsibility?
• Summary of Cases: The narratives above are illustrative, not real individuals, but they reflect documented scenarios (e.g., RS. 6,500 in ECS penalties, 50–70 point credit-score drops for one missed EMI, 75% without emergency funds). Use these facts to ground the discussion. Ultimately, this case is about bridging the gap between loan documentation and borrower reality – a vital lesson for anyone entering banking, finance, or public policy.