Chartered Accountants

There are lot of articles on personal loans.

Why do you require personal loan?

First ask yourself whether you really require personal loan. A loan is required as you don’t have sufficient cash to meet immediate expenditure.

 So you have to analyse why is this expenditure required? Is this important? Can you do without this expenditure?

If this expenditure is necessary, then why can’t you raise your income to have sufficient cash?

There are certain expenditures made on emotions like buying a car, Mobiles by taking personal loan. I would advise you to wait till you accumulate that much cash and buy that on cash instead of loan.

Also there are emotional decisions which are made by some of the husbands and the consequences have to be paid by the entire family like marriage expenditure of brother/ sister even though sufficient funds are not available. They take personal loan and then their wives and children have to suffer the burden of EMIs.

So if you can’t afford it, it is better to say no than to suffer the consequences of EMIs

I feel personal loan is justified is taking that for medical expenses, or for incurring an expenditure which will increase the future income.

Personal loans are one of the easiest that a borrower can take. Its biggest benefit? There are no questions asked, no proof demanded, no criteria to be met. This is unlike other loans, such as those for education, where you need to show proof of admission, or a home loan, where the house is used as security. While every bank provides personal loans, financial experts, including loan providers and websites, advise borrowers against taking these. Why?

The primary reason is that these are one of the most expensive loans as the interest rates vary between 16% and 30%. The extremely high interest rate is justified because the borrower doesn't need to provide a collateral. The amount of loan is calculated by taking into consideration the current financial status of the borrower and his cash flow, such as salary, rental income, profit and loss in business, servicing of other loans, etc.

But if the product is so maligned, why does it exist? Can taking a personal loan be beneficial? Yes, it can, depending on the circumstances of the borrower. Here are three situations which justify taking a personal, provided there is no other option available, such as borrowing from parents or friends.

Settling a debt which has a high interest rate

If you are repaying a loan that has a very high interest rate, while that of the personal loan is lower, it will be better to opt for the latter. You can use the personal loan to close out the higher interest debt. For instance, at times, when people require cash urgently, they borrow a small amount from money lenders, where they only pay the monthly interest and promise to pay the principal at a later time. This interest is usually on the higher side ranging from 1.5- 3% a month. If you can repay the principal in less than six months, you can keep paying the interest on a monthly basis. However, if you will take longer to repay the principal amount, it is better to go for a personal loan and use it to settle the earlier loan.

Say, you borrow Rs 1 lakh from a money lender for your sister's wedding. The interest is Rs 2.5 per Rs 100 a month (2.5% interest a month), which means you will have to pay Rs 2,500 every month as interest. In a year, you will pay Rs 30,000, while the principal would still be Rs 1 lakh, so your effective outgo will be Rs 1.3 lakh.

In such a case, you can take a personal loan to repay the money lender. A loan of Rs 1 lakh for two years at 18% a year means an equated monthly instalment of Rs 4,992. After two years, you would have not only paid off the entire loan, you would have paid only Rs 19,818 as interest, much less than the Rs 30,000 you would have paid the money lender as interest for one year.

Also, as a personal loan is with a bank, you get the opportunity to create a good repayment record which will, in turn, create a good credit history. You can leverage this later to get higher loans at lower rates.

Paying off a large credit card balance

A personal loan can also be used to pay off a substantial credit card balance that is being rolled over for months. Paying just the minimum amount on the card bill will not help you as the interest is charged over the total bill amount and is very high, usually 2.5-3% a month. It's better to divert the money to paying the EMI of a personal loan. You could save 16-30% depending on the rate of interest you are able to get on the loan.

Suppose, you have been on a shopping spree and spend Rs 2.3 lakh on your credit card. You may be unable to pay this large amount in one go and could pay the minimum balance every month. However, after six months, you will still have a balance of Rs 2 lakh. To clear this amount, you can use the following options—continue to pay the minimum amount every month, pay a fixed sum every month or take a personal loan.

If you pay only the minimum amount (5%), it will take you 350 months to clear your bill and the total payout will be approximately Rs 4.78 lakh. If you choose the second option and pay Rs 10,300 as a fixed amount every month, it will take you 30 months to settle the debt. In this case, the total outflow will be Rs 3.09 lakh. The best choice is to take a personal loan of Rs 2 lakh and settle the card amount. If the interest rate for the loan is 18% a year, the EMI for two years will be Rs 9,985 and your total payout will be Rs 2.40 lakh.

This means you will save Rs 2.38 lakh over the first option or Rs 69,000 over the second one. Also, paying the minimum balance on the card will require around 30 years, while taking a personal loan means you will be debt-free within two years. Another benefit is that as the card balance will have been paid, you can continue using it to pay for purchases as well as to withdraw money in case of an emergency.

For higher education

The third scenario when taking a personal loan could be considered good is for higher education. This will not be helpful at the graduate level as the duration of the course will likely exceed the loan repayment period. Also, the chances of getting a high salary to compensate for the interest outflow is lesser.

This is more useful for a professional course. The personal loan can be utilised in situations where you need funds quickly and cannot provide proof of admission on time, when you need more funding or if you do not want to pledge collateral. However, take this route only when you cannot procure an education loan or if you need to top up the funding.

The reason why this is a good option is that education is an asset which will provide good returns throughout life. The price to pay for this is the interest paid on the personal loan and, probably, a simple lifestyle till the loan is repaid or you land a lucrative job offer.