Personal loan primer: Essential tips before taking the plunge

Rajesh, a 35-year-old IT professional living in Bengaluru, learns that his father, who resides in Patna, has been hospitalised due to a severe illness. The treatment costs are estimated to be quite high, and Rajesh urgently needs to arrange the funds. Unfortunately, he does not have sufficient savings to cover the medical expenses and must act quickly to ensure his father receives the necessary treatment.

Solution: Personal Loan

Rajesh decides to apply for a personal loan to manage the emergency medical expenses. Here's his process:

He spends a few hours researching various banks and financial institutions that offer personal loans in India, comparing interest rates, processing fees, loan tenure, and the speed of disbursal. Eventually, he selects a bank that offers competitive interest rates and fast processing time. He applies online, filling out the application form and submitting necessary documents such as proof of identity, address, and income.

The bank reviews Rajesh's application, assessing his creditworthiness based on his credit score, income, and other factors. Due to Rajesh's stable job and good credit history, the bank approves his loan application within 24 hours. Thus, Rajesh is able to manage the emergency medical expenses without exhausting his savings or compromising on the quality of his father's treatment.

"Unlike some alternative financing options that are used for specific purposes, such as home purchases or vehicle acquisition, personal loans provide borrowers with the flexibility to use the funds for a wide range of purposes, including covering medical expenses, consolidating debt, funding education, or meeting unforeseen emergencies. The versatility of personal loans makes them an attractive choice for individuals seeking financial flexibility," Adhil Shetty, CEO of Bankbazaar.com, tells Business Standard.

But is it a recommendable choice?

While personal loans can be a viable solution for addressing short-term financial needs, borrowers should approach them with caution, carefully evaluating their repayment capabilities and adhering to a responsible borrowing approach. Defaulting on personal loan repayments can have adverse effects on credit scores, limiting future borrowing options and increasing borrowing costs, Adhil Shetty explains.

Under what circumstances should one rethink opting for a personal loan?

Despite competitive rates, personal loans often carry higher interest rates compared to secured loans like home or car loans. If the offered interest rate is substantially higher than other available options, borrowers should reassess whether the loan is cost-effective, especially if they have access to collateral for a secured loan. Additionally, if the borrower already has a significant amount of debt, adding a personal loan could overextend their financial obligations.

What are the essential questions to ponder before securing a personal loan?

According to Shetty, borrowers must be clear about the purpose of the loan. Assessing affordability is crucial; calculating monthly income versus expenses to determine manageable repayments is essential. Understanding interest rates and fees is vital; comparing offers helps find competitive rates and favourable terms, considering hidden charges. Additionally, evaluating the loan's repayment timeline to align with financial goals minimises interest costs. Finally, considering the consequences of default, such as the impact on credit score and potential legal actions, is important.

How do lenders determine the terms and amount of a personal loan?

Lenders assess the borrower's creditworthiness by examining their credit history, including repayment behaviour and existing debts. A strong credit history often results in more favourable terms, such as lower interest rates and higher loan amounts. Additionally, lenders evaluate the borrower's income and employment stability to gauge their repayment ability. A steady income source and longer job tenures are typically viewed positively. Lenders also consider the borrower's debt-to-income ratio, reflecting their financial health and capacity to manage additional debt. A lower debt-to-income ratio may lead to larger loan amounts and better terms.

How best to repay the personal loan?

It is advisable to prioritise timely payments to avoid penalties and maintain a positive credit score. Setting up automatic payments or reminders can help ensure consistency. Secondly, consider allocating extra funds towards loan repayments whenever possible, which can reduce the principal amount and shorten the loan term, ultimately saving on interest costs. Lastly, allocating a portion of monthly income specifically for loan repayments ensures timely and consistent payments, Adhil Shetty advises.

PaisaBazaar has compiled a list of the most popular personal loan plans in India for 2024