Five points to keep in mind before taking a personal loan financial planning 30stades
Taking a bank loan or any other loan to fund a big purchase or upgrade your lifestyle was taboo in India not very long ago. But things have changed dramatically in recent years. Loan-based funding of big-ticket purchase purchases such as household appliances, furniture, two-wheelers and cars is common.
What's more, many people are now resorting to personal loans from banks and non-bank finance companies to fund their children’s education, weddings, family holidays at exotic locations and even mobile phones. The overarching theme is to stretch one's purchasing power to its maximum limit.
There’s no harm in taking a loan as long you have the financial ability or the income to service it.
But some loans like your credit card debt and personal loans can turn into a financial headache if not planned carefully.
Here are five things to keep in mind if you are planning to take a loan to fund a big ticket purchase.
1. The loan amount. This is the most important thing to consider if you are planning to apply for a loan from a bank or any other lender. Higher the amount, the longer and tougher it will be to repay it. So make the best possible cost estimate of the purchase you plan to fund with the loan, calculate your self-funding ability and then borrow only the essential amount and self-fund the rest.
You can reduce loan requirements further by spreading your purchases over a period of time and requesting a short–term credit from the sellers or the suppliers.
This can work wonderfully if you are renovating your house or planning to equip your house with modern appliances.
Remember that loan servicing and repayment require you to make financial sacrifices in future so the loan amount should not exceed your ability to make sacrifices in future.
2. Interest Rate. The rate of interest that the lender will charge is one of the most important variables to keep in mind while taking the loan. The rate of interest directly impacts the equated monthly instalment (EMI) on the loans and thus your repayment ability. The higher the interest rate, the greater the EMI amount and the longer it will take you to repay the loan.
The interest rate varies greatly from one lender to the other and it also depends on the nature of the loan and the kind of things or activities that you plan to fund with the loans. So you need to do your research and find a lender with the lowest interest rate in that category. As a general rule, the interest on home loans is the lowest while personal loans and credit card debt attract the highest interest rates. Also, banks generally offer the best interest rate while small non-banking finance companies charge the highest interest rate. The interest on car or vehicle loans fits somewhere in the middle.
If you or your family owns a residential property or you already have a home loan running with a lender, then opt for a top-up loan, home equity loan or loan against property.
Top-up loans come at a much lower interest rate than vehicle loans or personal loans.
As a thumb rule, you shouldn’t opt for a loan with an interest rate higher than the expected annual increase in your income or cash flows in future. In other words, if you expect your income or salary to increase at the rate of 10 per cent per annum (based on past trends) only go for loans with an interest rate of less than 10 per cent or lower.
3. Loan tenure or the repayment period. Ideally, the loan tenure or the repayment period on your loan should be as short as possible, but if the loan is big such as in the case of a home loan, home construction loan or vehicle loan then repayments are longer. The longer the repayment period, the lower the monthly EMI on the loan but extending the tenure means you will pay more interest on the loan and for a longer time duration.
Shorter tenure translates into higher EMIs that may put an additional burden on your monthly cash flows. So choose loan tenure such that you are in a position to pay the EMI amount every month without compromising your other essential expenses and bills.
As a general rule, the repayment period for a car or vehicle loan should not extend beyond 60 months or five years and a home loan shouldn’t extend beyond 15 years.
4. The monthly debt servicing cost or EMI. The EMI determines the affordability of the loan given your salary or the monthly cash flows that you get. EMI is generally determined by the lender at the time of loan disbursement itself and the amount consists of a portion of the principal amount as well as the interest amount.
Don’t get carried away by the “attractive” EMI offered by the lenders but get a clear break-up of its principal and interest component.
The lower the principal component in the EMI, the longer it will take you to repay it and you will be paying a higher interest rate on your loans. Most lenders now offer EMI calculators on their websites, so calculate the approximate amount you may have to pay every month before applying for a loan. As a general rule, the combined EMI on all your loans should not exceed 50 per cent of your take-home salary.
5. Processing fees and other charges on the loan. Lenders not only charge interest on the loan but also processing fees, disbursement charges and stamp duty while approving the loans. These charges can add up to a hefty amount and you have to keep this in mind while selecting the right bank or lender for you.
For example, in the case of home top-up loans and loans against property, the upfront total processing fee could be equivalent to two EMIs which can be a big burden on your cash flows in the short term.
Hence it’s important that you add all those non-interest charges when comparing the real cost of availing the loan from various lenders.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).
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