Personal Loan – What you need to know

What is a personal loan?

Personal loan is a type of loan where you borrow money to fulfil a variety of needs and wants. Mostly, in a personal loan, you are free to use the funds any way you wish, like paying for a vacation, debt consolidation, etc. It is mainly availed for financing large purchases.

Features of Personal Loan:

1. Interest rate depends on your Income and credit. No need for collateral.
2. history, where interest rates can go up to 130% for risky borrowers. Insane, right?
3. Loan tenure is from 3 to 60 months depending on the amount. 
4. Minimal Docs enough – ID proof, Address proof, Income proof.
5. Faster Processing Time where loan is processed within minutes.

Common reasons for taking out personal loans

1. Buying a Gadget
2. Medical Emergency
3. Emergency Expenses.
4. Vocation
5. Wedding
6. Debt consolidation, where you clear all your high interest rate debt and credit card debts with one single personal loan.
7. Downpayment for house.
8. Vehicle financing.
9. To start a new business.
10. Improve your credit history.

When personal loans are beneficial than other types of credit

• When you don’t have any collateral/assets with you.
• When you need the loan on the same day.
• When there are many different expenses.
• When you like to pay fixed EMIs than varying EMIs.
• When you are thinking of opting for a credit card for money needs, also check the interest with the personal loans as they can go way beyond credit card interest rate if you are a risky borrower.

Eligibility Criteria for Personal Loans

Income Requirements

It depends on lenders. While NBFCs may offer loans to people with low income like ₹25000 or ₹10000 Or ₹20000, other standard and popular lenders may have a starting limit of ₹40, 000 like in ICICI Bank.

Credit Score Considerations

1. Credit score is one of the key factors in deciding the approval of a personal loan. Credit score usually ranges from 300-900 where 300 is the lowest and 900 is the highest. 
2. There are many companies that provide your credit score based on their analysis. Popular ones are CIBIL, Equifax, Experian. 
3. People with above 750 score usually get better interest rates and higher loan amounts while people with below 750 slammed higher interest rates and lower loan amounts. 

Employment Status

1. Your employment status can make or break your loan. It’s crucial for applying for personal loans. While 95% of lenders don’t loan to people who are not in a job, 5% do. These are mostly NBFCs slamming you with high interest rates upto 130% and lower tenure like 3 months. 
2. So if you don’t have a job with income proof and employment stability, forget getting loans from standard lenders. 
3. But that’s not a problem because you can get loans from various lenders because these days there are so many lenders with flexible terms. So worry not. 

Debt-to-Income Ratio

1. Debt-to-Income Ratio is a percentage that tells how much of your income goes to debt. For example, if you’re earning 50k, and 25k goes in debt, then (25k/50k) multiplied by 100 gives you the debt to income ratio. Here it’s DTI = 0.5*100= 50%.
2. One can see the DTI ratio and instantly decided whether you’re a safe borrower or a risky borrower. 
3. DTI ranges
   1. <20% – Strong candidate for loan. 
   2. 20-35% – Good candidate for loan. 
   3. 36-40 – Decent candidate for loan. 
   4. >40% – Risky candidate for loan.

APR (Annual Percentage Rate)

It’s the percentage that shows us the total cost (in %) of borrowing money from that lender. It includes interest rate plus additional fees, charges for the lending of the money. 

APR is used by borrowers to know how much a loan is costing them, compared to APY (annual percentage yield), which is used by investors to see their return from compounding. 

APR is useful when comparing different loan products. 

The nominal interest rate only gives us just the interest rate whereas APR gives us a more clear picture of how much it’s costing to take up the loan. 

Fixed Interest rate (FIR)Vs Variable Interest Rate (VIR)

1. The rate of interest is fixed for the lifetime of the loan in the fixed interest loans whereas the interest rate varies going up and down during the loan’s tenure after the initial period of 3-5 years. 
2. FIR is suitable for people who like the comfort of paying a certain amount every month with fixed monthly income and like to not bother with market conditions whereas Variable rate is suitable for people who think the market conditions will get the interest rates lower at times making the payments lower. 
3. In variable interest rate, the first 3-5 years of monthly payments can be lower compared to the fixed rate loans.

How Interest Rates are determined

Many factors influence interest rates. The main factors are creditworthiness of a borrower, their credit history, government monetary policies, inflation rate, repo rate, etc. 

Creditworthiness and income are two factors mainly determining the interest rates while taking out a loan. Lenders often offer lower interest rates and higher loan amounts to people with great credit scores whereas people who have lower credit scores, typically under 700 may get higher interest rates with lower loan amounts. 

DTI is another factor in determining the interest rates. When DTI is above 50%, the lender may take more risk and increase the interest rates. 

Impact of credit score on Interest rates. 

Credit score is a critical factor because it shows the lender the past history and the credit behaviour of the borrower.

Interest rates can go crazy if the lender is not comfortable with lending or if the borrower is just meeting their minimum criteria.

Higher credit scores give a positive sign to the lender that the borrower has been diligent with the credit. 

Negotiation Better Rates: The interest rates can be negotiated if the borrower has a stellar credit score and has a great reputation with the bank. 

How Lenders Use Risk Assessment to Set Rates

Lenders cater to a variety of borrowers with varying credit scores. So it’s not possible to give the same terms to everyone. For this purpose, the lenders use risk based pricing where the lenders check certain metrics of the borrower before lending and setting the rates. Main factors include

Credit score : Higher the score, lower the interest rate. 

Repayment History: Careless behavior or late payments or defaulting signals the borrower is a risky one. 

DTI ratio: Typically below 50% is the limit. Above 50% indicates that the borrower might default.