Personal loans are a great way to acquire a large sum of money in a short span and then pay it off in small monthly instalments. It may be used to pay for your dream wedding, shifting houses, expected medical bills, paying off debt, or any other personal reason.
It is different from a home or car loan as it does not require collateral as security. The loan is given based on a borrower’s credit score, and future repayment ability. Since there is no collateral involved, the lender undertakes higher risk and thus charges higher interest for it.
Oftentimes, in the lure of lump-sum money, people forget to carefully analyse the personal loan and end up in situations of EMI burden and even legal proceedings due to a default in payment.
It is important to understand all aspects of a personal loan and derive your eligibility for it instead of just focusing on procuring the amount. In this post, we highlight 10 key factors to keep in mind while applying for a personal loan with your bank.
1. Is a personal loan your best bet?
Taking a personal loan is a liability that you’ll have to bear for the span of EMI payments. This means an added expenditure for months or even years. Thus, before applying for a personal loan, ask yourself, is it your best option? Can you use your savings for this purpose? Can the expense be delayed?
Some banks offer an overdraft facility for emergency expenses. Ask your provider if you can avail it. Further, as mentioned before, personal loans carry a high rate of interest. If you do not wish to pay it, you may consider options like loans against fixed deposits, gold loans, etc. Since they are backed by collaterals, the interest rate would be significantly lesser.
Due to the high accessibility of personal loans, people view it as easy lump-cash cash and often use it to go on a luxury vacation or buy a new gadget. It is not in the best interest of your financial health to do so. A personal loan should be used only for emergency and unforeseen expenses.
2. The loan structure
The loan structure defines the effectiveness of a personal loan. It is essential to choose the right loan structure, according to your needs. It includes-
Choosing the right loan amount
This is a very important factor. When applying for a personal loan, you must access your needs at the moment to derive the exact amount of money required. The loan amount should not be more than what you need. People sometimes go overboard with the loan amount and end up in a debt trap.
The right proportion of EMI span and Interest Rate
The duration that you have to pay back the loan is inversely proportional to the interest you pay on every instalment. The Shorter the time span, the higher the monthly instalment amount will be. If you wish to have a lower interest rate, talk to your loan provider about an increased span of EMIs.
3. Repayment span
Before taking a personal loan, you should consider how you will repay the loan. Repayment starts within 30 days of acquiring the loan amount, thus, if you’re planning to take a personal loan due to a short-term cash crunch, use a loan calculator to access the exact amount you will have to pay for the loan, every month.
Some banks offer an auto-pay option for your personal loan that reduces the annual percentage rate or APR by one-fourth or even half. As a borrower, you have the freedom to choose the repayment plan that works for you.
As a general rule of thumb, a lender should not spend more than 40% of his/her monthly income on debt.
4. Interest rates
Interest rate is the key feature of a personal loan and must be analysed carefully before choosing a plan. Some lenders show attractive rates of interest to lure high volume loans. However, it might not be the best plan. What looks like a small percentage in the starting could increase significantly over the months.
To derive the right interest rate for your loan amount, it is important to understand the two interest rate structures that lenders employ in personal loans.
The flat-rate structure of calculating interest takes the entire loan amount into consideration and derives the interest rate on the full amount. For instance, if you’ve taken a loan of Rs. 1,00,000 at a flat interest rate of 12% for 2 years, the interest you will pay for one year would be Rs.24,000 (12,000*2). Simple, isn’t it?
Reducing Balance rate structure
The reducing balance rate structure calculates the interest amount considering your monthly repayments. Going by the above example, if you’ve taken a loan for 1lac with 12% interest for 2 years, the interest for the first month would be charged n 1lac but with subsequent repayments, the interest will be charged on a reduced amount.
It is not in the borrowers’ hands to choose this rate structure, but they can surely check which structure their lender is using. Most lenders employ the reducing balance rate structure as the interest derived from this method is higher than the flat rate.
As a borrower, you should look for the reducing rate structure, instead of getting wooed away by low-interest rates that are probably employing the flat rate structure.
5. Your credit score
The credit or CIBIL score of a person highly determines the kind of loan they will get. If you maintain a good credit score, the interest rate levied on your personal loan is lesser and the loan amount you can take increases. The credit score may range anywhere between 300-900. A score above 700 is considered ideal.
Every time you file for a personal loan, the lender pulls out your credit report to determine your eligibility for the loan. If you apply with multiple lenders, your credit report will be pulled out multiple times. This practice has a negative impact on your CIBIL score. Thus, one should access the eligibility of a lender and apply to the selected one only.
To maintain a good credit score, one should employ the following measures:
- Punctuality in the repayment of loans,
- Using one credit card with a good credit history instead of various different cards, and
- Not utilising more than 30% credit.
6. Feasibility of the personal loan
Many personal loans don’t show the lender the full picture and often have hidden costs that came as a surprise later on. To avoid this situation, read the loan agreement very carefully to analyse the various costs charged by the lender.
Some Personal loan costs may include a processing fee, prepayment fee, sign-up cost, late-payment fee, and multiple other charges. As a borrower, you should look for a lender that does not have any additional costs involved. Even a small fragment like a 1% origination fee can be a large amount for you in the future. Ideally, only interest should be charged by the lender.
7. Unforeseen circumstances
While taking a personal loan, you should consider the possibility of not being able to repay it. The pandemic of 2020 led to a lot of loans becoming NPAs for the bank due to job losses and pay cuts. Thus, you should be prepared for any such unforeseen circumstances.
Not being able to repay a loan can land you in major financial and legal trouble.
To avoid this situation, you can consider buying an EMI protection insurance plan. It will allow you to skip your monthly instalments for a short period. You can use this time to stabilize your income and arrange for resources to pay back the loan.
8. Eligibility of the lender
Before choosing a personal loan plan, you should perform comparative industry research to find out the best lender for your needs. There is a lot of competition in the loan sector. Every other financial company wants to sell you credit. This practice gained even more momentum with new and emerging fintechs in the market.
To qualify a lender as your service provider, you should check its credibility in the market. Reading customer reviews, going through the company portfolio and past performance also helps get leverage as a borrower.
9. Need-specific plans
Some personal loan plans also offer custom need-based solutions. For instance, if you’re taking a loan to pay back some debt, there are certain debt consolidation plans that enable the bank to send the amount directly to your creditor, skipping your bank account, and the additional charges that come with it, altogether.
Thus, while taking a personal loan, consider if your bank has a specific plan for your need.
Borrowing from the bank for your personal needs looks easy, but comes with a whole set of other considerations. You must be well-versed with the insurance plan to avoid getting exploited by the lender and protect yourself from future legal chaos.