Do not fall in trap of personal loans to finance festivities

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It’s that magical time of the year when festivities abound, gifts are exchanged and one sets out to buy new things.

Some have planned it well and have savings set aside for their purchases; for others, borrowing is the only option. A quick way to borrow lumpsum amounts that can be used for any general purpose is to take a personal loan. Banks are quite happy to lend money to you.

But should you throw caution to the winds and take a personal loan for every need, even not so important ones?

By virtue of it being unsecured, personal loans have a very high rate of interest attached to it. So one should consider taking a such loans if and only if

* You do not have an asset or security against which you can get a loan. For example, if you have a fixed deposit, you can pledge, a secured loan might make more sense.

* You have some visibility on your future cash flows and are sure that you will be able to repay the EMIs in time. If not, you are bound to enter into a debt trap.

* There is an emergency and you need funds immediately. A personal loan can be taken because the processing time is much less on account of minimal documentation.

Opt for personal loans only to meet your essential needs which cannot wait rather than for frittering it away on consumer goods. It should be your last resort. Taking a personal loan for satisfying leisure needs can prove to be costly. A car loan, for example, is better than a personal one since the former has a lower interest rate. What factors will determine your total loan cost?

Interest rate is not the only cost associated with the product. Several charges can be levied which will affect the overall cost of the loan.

Charges levied

Processing Fee: This is charged from the borrower to process the loan application. It is typically between 1-2 per cent of the loan amount. Some banks charge a flat fee. This fee is to be paid up front with the loan application and supporting documents.

Pre-payment Fee: If the EMIs are paid before the tenure, banks will normally charge the borrowers a pre-payment fee which will be in the range of 2 to 5 per cent of the outstanding loan amount. Usually, pre-payment is permitted only after a certain period of the loan disbursal.

Late payment penalties: If there is a delay in paying off the monthly EMIs, banks will levy a late payment fee with the EMI. It usually is in the range of 2 to 3 per cent.

Cheque bounce charges: If you have given post-dated cheques and they are not honoured by your bank on account of insufficient funds, you will be charged a penalty for cheque bouncing. Banks charge anywhere between Rs 250 and Rs 500 for the same.

Documentation charges: These are the charges for verifying the borrower’s documents to processing the loan application. Most banks employ a third party vendor for this purpose. Charges are anywhere between Rs 500 and Rs 1,000.

How to select the best personal loan offer?

For selection of a personal loan that will offer you maximum benefits, consider the following factors.

Rate of interest: This will differ from bank to bank depending on their assessment of your risk profile. Factor in your total interest outgo while comparing the total cost of the loan offer between banks.

Amount of loan: Check if the bank is providing you a loan sufficient enough to meet your financial needs.

Tenure and EMIs: If it is a shorter duration loan, the EMIs will be higher and vice versa. So if you feel you will not have sufficient funds to pay off high EMIs initially, then this factor will be important too. On the other hand, a shorter tenure might help you close the loan earlier and with less interest too. Work this out carefully.

Other charges: As mentioned earlier, there are several charges levied by the bank, which will have an impact on the total cost for you. Hence, let not interest rate be the only factor you consider from the cost angle. Take the total cost into consideration.

Clearly, such loans are not as simple as they look. Take a loan if you must, but exercise care so that you are not saddled with a debt.

(The writer is the CEO of bankbazaar.com)