Personal Loans – De-mystified

The title sounds interesting and so will the article. Again, this is something I have wanted to write for quite some time. Personal Loans have become pretty famous over the past decade and almost every bank in our country is giving personal loans to its customers. If you are someone working in an IT Park or a Industrial Park, you would have definitely seen people from a number of banks waiting with colourful pamphlets in their hands near your office gates trying to sell you one. If you are one such person and have been tempted to think, shall I take this because this guy says its very low interest, this article is exactly for you. For the others, its always good to know about certain things that maybe useful for us. Ok, lets get started.

What is a Personal Loan?
A Personal Loan is an agreement between a lender (bank) and a borrower (customer) wherein the lender offers a fixed sum of money to the borrower which the borrower agrees to repay as equal monthly instalments over a fixed duration of time. The definition of other commonly known loans like a car loan or a home loan is almost the same as above with just one small difference. In case of a home loan or a car loan, the bank can lay claim to your house or car if you fail to repay the money. The Personal Loan is an unsecured loan wherein, the bank does not have any guarantee to your payment.
The documentation is relatively quite simple and you will get the money within 7-10 working days. Repayment terms are quite flexible, usually between 1-5 years. All this makes them very attractive.

Below are a few things you need to keep in mind before taking a personal loan…

Do you ‘really need’ this Personal Loan?

This is the most important question. Do we really need the loan is something we must ponder before taking the decision of applying for one. Be Cautious!! The loan may be easy, but that doesn’t mean that it is good for you.

There are two main reasons for such a warning.

First of all, personal loans are usually taken to go on a vacation trip, buying stuff for home such as LCD/Plasma TV or for a marriage, etc. All these are mainly personal use items. Taking loans to finance consumption is one of the worst financial mistakes you can ever make. Financial prudence suggests that you should always save some money regularly. Getting a PL is doing exactly the opposite i.e., spending today out of the unearned (and possibly uncertain) future income.

Secondly, these loans are quite expensive. Though your loan agent may say that the interest is low, it is still high.
A Point to Ponder:

A Bank makes money by giving loans to people and we make money by depositing surplus cash with the bank and earning an interest. If banks offer us interest rates of around 8% per year and they need to make a good profit on the money you deposited with them – imagine at what rates they will lend it?

So think twice! Do you really need to take this burden?

When does it make sense to apply for a personal loan?

Sometimes, personal loans may not be such a bad idea. It can 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 monthly income. And currently you don’t have any investments or FDs or some other savings, which you could utilize for paying the credit cards. Then, it may be wise to take a personal loan to pay-off the credit card bills, as the interest rate on credit cards could be 2-3 times that of a personal loan. Thereby, you would be saving a lot on the interest.

Or there could be a medical emergency that requires fairly large sums at a short notice.

Consider the alternatives

Before you jump on to the easy decision of taking the PL, consider other alternatives. Can your family, friends, or colleagues help you out in your financial crises? Your current situation could 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? Or 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 would be willing to lend you money against the future rental income from the property.

The above mentioned options are cheaper options to get money (of course the first being the cheapest wherein you usually do not pay interest to your friends or family) rather than pay higher interest on personal loans.

A Point to Ponder:

Have you ever wondered why banks offer mortgage loans or loan against securities at much cheaper rates than personal loans? The reason is the mortgage loans are safer for banks because if you do not pay them off, they can take possession of whatever is mortgaged and recover all or part of the debt you own them. Whereas in case of personal loans, the bank has no such option. Hence they charge you more, trying to recover as much money from you in the shortest span of time.

How much should you borrow?

Banks will work out your loan eligibility based on your income, age, commitment & liabilities, work experience etc. They would also take into account whether you are a salaried person or self-employed. A joint applicant like a working spouse would also enhance your loan limit.
Just because the bank says that it can lend you a certain amount, 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 with which you can repay it. How much money is absolutely essential? How much EMI can you afford every month without compromising your living style? 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? Etc…

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 15-20% of your monthly take-home salary. Worst case scenario try to cap it at 25% of your salary.

Documents required for a Personal Loan

As mentioned earlier, the documentation required for applying for a personal loan is very minimal as compared to many other loans.

They include:

One or two Photographs
An Identity Proof: PAN card, passport, or driving license, etc.
Residence or Address Proof: 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. If you are an existing customer to the bank, they may opt to process the loan with lesser documentation.

To Conclude: A Personal Loan is a boon for the needy. It is an easy way to raise money for emergencies or urgent requirements. But, if you can avoid taking the loan and manage without it, it is all the more better.