How Gold Prices Affect Gold Loans

1. Introduction

• Brief explanation of gold loans: Gold loans are a type of asset-backed loan, where the borrower collateralises their gold ornaments to secure a loan from the lender. Once the loan is repaid to the lender in full, including principal, interest, and any applicable charges, the custody of collateralised gold is given back to the borrower.

• Why gold price movements matter: Gold price movement is an important factor which influences the amount of loan that can be availed against the gold collateral. A higher gold price can translate into a higher valuation of the gold collateral, meaning a higher amount of loan can be taken, and vice versa.

2. Understanding Gold Loans

• What is a gold loan?

Gold loans are a type of collateral-backed loan. The working of the gold loan is similar to any other form of loan, where the borrower repays the loan along with the interest as stipulated in the loan contract, along with other applicable charges. The only difference is that the borrower collateralises their gold to avail the loan. The borrower’s gold serves as security for the lender, i.e. in the event of a default by the borrower, the lender reserves the right to liquidate the gold collateral to recover the dues.

• How lenders determine loan eligibility

Lenders determine gold loan eligibility based on the value of the gold, which depends on various factors such as the purity, weight, and type of the gold collateral, as well as the market value of the gold. A combination of these factors helps the lender calculate the amount of the loan that can be given against the said collateral.

• Key components: LTV ratio, purity, valuation, interest rates

Several key components influence the gold loans. Such as the LTV (Loan-to-value) ratio, which essentially is the amount of loan that can be given as a percentage of the gold’s market value. If the gold’s market value is INR 100,000 and the LTV is set at 70% then the maximum amount of the loan that can be availed is INR 70,000. Other factors such as the purity of the gold - higher purity means a higher amount of loan and vice versa. Valuation of the gold, i.e. market value of the gold collateral, and interest rates applicable on the loan in the market.

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3. Factors That Influence Gold Prices

• Global economic trends: Global economic trends have a huge impact on the global gold prices. Gold has showcased great price stability, and in times of uncertainty in the financial markets, investors flock towards gold, boosting the global demand, which essentially increases the price levels, and vice versa.

• Inflation and currency fluctuations: Inflation and currency fluctuations also have an impact on the domestic gold prices. Since, in the international market, the gold prices are in dollar terms, for a falling currency, the gold prices can be significantly higher. The same applies to inflation. Since the money no longer holds the same value, inflation impacts the gold prices too.

4. How Gold Prices Affect Gold Loan Amounts

• Impact of rising gold prices on loan eligibility: Rising gold prices have a positive impact on gold loans from a borrower’s perspective. A higher gold price means that the borrower’s gold collateral’s value is also higher, which translates to a higher amount of gold loan, and vice versa.

• How lenders revalue gold during loan processing: Lenders revalue gold based on various parameters, such as the prevalent gold price in the market, the gold’s purity, net weight of the gold (excluding the weight of stones/diamonds, etc). Lender’s LTV ratio policy. Lenders like indiagold offer one of the best gold loan in India with among the highest LTV ratios in the gold loan market.

• Effect on maximum loan amount (LTV calculations): Loan-to-value (LTV) ratio affects the amount of loan that can be availed against the gold collateral. A higher LTV ratio is beneficial for the borrowers as it allows them to borrow more against their gold collateral, and vice versa.

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5. Impact of Gold Price Fluctuations on Interest Rates

• Whether interest rates change with gold prices: Gold price fluctuations have a minimal impact on interest rates. Neither is correlated. Gold rates internationally are driven by supply and demand forces, i.e. a higher demand for gold fuels the gold prices, and vice versa. Whereas, the interest rates are impacted by the conjunction of the lender’s lending policy, the risk associated with the lending, and the base interest rate set by the central bank.

• How market volatility affects lending risk: Market volatility increases the lending risk for the lenders. Volatility is essentially the frequency at which the gold prices change. Since gold loans are given based on the LTV, where the base of the LTV is determined by the gold collateral’s market value (derived from gold’s market value), high volatility makes it less predictable for the lenders to set an LTV ratio which aligns with their risk appetite. This often results in the risk exposure exceeding desirable levels for the lenders.

• Lender strategies during unstable price periods: During unpredictable price periods, the lenders refrain from giving loans at a higher loan-to-value ratio (LTV), and often increase their interest rates to account for an increased risk exposure.

6. Effect on Loan-to-Value (LTV) Ratio

• How price increases/decreases impact LTV: Loan-to-value (LTV) ratio is the ratio of the maximum loan amount as a percentage of the value of the gold collateral. Let’s understand this with an example. Let’s suppose the value of the gold collateral is INR 100,000, and the LTV value is fixed at 70%. Then, the maximum loan amount that can be availed against the gold is 70% of INR 100,00,0, i.e. INR 70,000. A price increase in gold essentially means an increase in the base price of the calculation, which translates into a higher amount of loan and vice versa.

• Why LTV is a critical factor for borrowers: Loan-to-value (LTV) ratio is a critical factor for borrowers as it dictates how much loan a borrower can avail against their gold collateral. This is tied to the gold’s market value and the lender’s risk appetite. A higher LTV offered by the lender means that a higher loan amount can be availed against the said gold collateral and vice versa.

7. How Falling Gold Prices Affect Borrowers

• Risk of margin calls or additional collateral: falling gold prices can trigger a margin call, especially for borrowers who have availed the highest possible loan amount from the lender. To keep the risk exposure in check and the borrowed amount under the maximum LTV ratio, the lender may ask the borrower to repay a part of the borrowed amount during times of falling gold prices.

• Possibility of auctioning pledged gold: In a rare event that the gold prices fall tremendously, and the borrower is unable to pay the difference, the lender might have no option but to auction the gold to recover dues. Hence, it is advised to only borrow from reliable lenders with well-framed policies and transparency, like indiagold.

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