1. Do you find Personal
Loans attractive?
Personal loans are one of the simplest forms
of loans.
- They are easily available. In fact, many of you would be getting offers without even asking for it.
- They generally do not require any security or collateral or a guarantor.
- The documentation is relatively quite simple.
- You could get the money within 7-10 days.
- Repayment terms are quite flexible, usually between 1-5 years.
- There are no end-use restrictions.
‘No
security’ and ‘no end-use restrictions’ – these are the clincher.
All this make the personal loans highly
attractive. Hence, you are likely to fall for these loans quite easily. Who
wouldn’t want such easy money?
2. Do you ‘really need’ a Personal Loan?
Beware! The loan may be easy, but it doesn’t
mean that it is necessarily good.
Therefore, before you go ahead, it would be
prudent to issue a warning (something similar to the one on cigarette packets)
– Personal Loans are injurious to Financial
Health.
There are a couple of reasons for such a
warning.
First, personal loans are usually taken to go
on a vacation trip, buying consumer durables such as LCD/Plasma TV, marriage,
etc. All these are mainly consumption items. Taking loans to finance consumption is one of the worst financial
mistakes you can ever commit. Financial prudence suggests that you should
always save some money regularly. This is doing exactly the opposite — spending today out of the unearned (and possibly uncertain) future income.
Secondly, these loans are quite expensive.
So think twice! Do you really need to take on
this debt-burden?
3. When does it make sense to take a personal loan?
Sometimes, of course, personal loans may not
be such a bad idea.
It could help in debt restructuring. Suppose
you have run-up a substantial outstanding on your credit cards and are finding
it difficult to pay it off from your regular income. Besides, you don’t have
any investments or FDs or some other savings, which you could utilize for the
purpose. Then, it may be prudent to take a personal loan to pay-off the credit
card bills, as the interest rate on credit cards could be 2-3 times higher.
Thus, you would be saving a lot on the interest.
Or there could be some medical emergency
requiring fairly large sums at a short notice.
Or it is nearing end of financial year and you
are falling short of the Rs. 1 lakh investment limit available under Section
80C to save tax. Again, a personal loan could be considered to meet the
shortfall.
4. Are there any alternatives?
But before you jump on to this easy option — explore
other alternatives.
Can your family,
friends, or colleagues help you out in your financial crises? It may be a
temporary problem and you could pay them back within a few months.
Do you have some
illiquid investment, such as an LIC policy? Do you have some bluechip shares,
which you don’t want to sell? It is possible to get a loan against such
investments and at a much cheaper rate.
Or you have a
property (preferably commercial) rented out on lease. Many banks may be willing
to lend you money against the future rental income from the property.
Thus, there are
many options to get cheaper money.
5. How much should you borrow?
Banks will work
out your loan eligibility based on your income, age, other liabilities, work
experience etc. They would also take into account whether you are a salaried
person or self-employed.
But it doesn’t mean that you should take
whatever maximum amount the banks are willing to lend.
You should work
out your need and the comfort level. How much money is absolutely essential?
How much EMI can you pay comfortably? Will you be able to meet all your fixed
expenses such as rent, school fees, telephone, electricity, travel, insurance
premiums, etc. without straining your budget?
As a thumb rule,
make sure that the total repayment per month on your personal loans, credit
card outstanding and such other similar loan facilities do not exceed more than
10-15% of your monthly take-home pay.
6. What is the interest rate?
The interest rates offered vary widely — ranging typically from 12% to even 30% p.a.
Different banks have different rates.
Different categories of persons e.g. salaried-class, self-employed etc. are
offered different rates. Even within the same category, the rates would differ.
For example, in the salaried class, a government employee may be offered a
lower rate. Besides, depending on your financial strength and bank’s
willingness to lend, you could always negotiate for better rates.
Therefore,
you must shop around extensively and bargain for the best deal possible.
Still, these rates are expensive. This is so
because these are unsecured loans. Banks have no recourse to any assets in case
of defaults. Therefore, they charge a higher rate vis-à-vis secured loans such
as a home loan, car loan etc.
Hence, as discussed earlier, if you have some
assets — such as equity, MFs or insurance
policies — which you don’t want to/cannot
sell, you can offer them as a security. This will mean lower interest cost and
hence reduced financial burden.
7. How is the interest calculated?
However, beware! Looking just at the interest
rate may not give you the whole picture.
For example, loans at low ‘flat rates’ may
appear cheaper. However, the flat rate concept does not consider the monthly
principal repayments and hence effectively the cost works out much higher. A
loan at 8% p.a. flat rate would actually mean interest of almost 15%.
Another strategy to market loans at lower
rate, but where the effective cost is much higher, is the advance EMI concept.
Here, the bank will ask you to pay 2-3 EMIs upfront. This is nothing but
effectively offering you a lower amount but calculating interest on a higher
face value of the loan. This also increases the final cost that you end up
paying.
How the reducing balance method is applied
i.e. annually, quarterly, monthly, daily could also mean a higher effective
cost than what is stated. Daily reducing methodology is the best or you should
at least opt for monthly reducing balance considering that you are going to pay
monthly EMIs.
The
trick here is to compare EMIs, not the interest rates. Ultimately, what goes out of your pocket is
the EMI. Therefore, lower the EMI, the better it is. As explained earlier, this
does not necessarily mean that the advertised interest rate will also be lower.
8. What are the other charges?
Interest,
of course, is the most significant of the costs. But that doesn’t mean you
should ignore the other charges. These would typically include processing fees, prepayment penalty,
documentation charges etc. These too could add up to a substantial amount.
Some banks charge fixed processing fees in the
range of Rs. 250-1000. Others link it to your loan amount ranging from 0.5-3%
of the loan amount. This will generally be a non-refundable amount payable
upfront (with possibly some percentage returnable in case the loan is not
approved).
Prepayment penalty may vary from nil to as
high as 5% of the loan amount.
Besides these, there could be loan
documentation charges (Rs. 500-2000), charges for duplicate statements (Rs.
100-500), late payment charges (1-3%), charges for cheques returns (Rs.
250-500), service tax, etc.
9. Other terms & conditions
Cost is one
aspect. However, that apart, there will be other operational terms and
conditions, which you need to be aware of beforehand.
For example, apart
from charging a penalty for prepayment, there could also be a minimum period
stipulated prior to which prepayment will not be allowed. Six months is the
typical period specified by many banks.
Further, some
banks may allow part-prepayment, while others may insist on full payment in
case you wish to prepay the loan.
Besides, banks may also stipulate other conditions such as
the right to revise the interest rate during the loan tenure; demand immediate
repayment of the loan irrespective of the repayment schedule fixed; repayment
or renegotiation of the loan in case you change your job; etc.
10. Documents required
As mentioned earlier, the documentation required for applying for a personal loan is very minimal
as compared to many other loans.
These would typically include:
- Identity Proof: For example, the PAN card, passport, or driving license, etc.
- Residence Proof: For residence proof, you could submit passport, ration card or electricity/telephone bill, etc.
- Income Proof: For salaried persons, the banks may ask for the latest salary slip, Form 16 and 6-months bank statement. A self-employed person would be asked to furnish 2-3 years IT returns, accounts, etc.
The exact requirement of documents may vary from bank to
bank.