10 Golden Rules to Follow When Taking a Loan

November 25, 2021 Mutual Fund

Debt has become an integral part of the aam aadmi’s life, except for a minority of people who can afford everything without any debt. But with the constant rise in inflation and the price of properties, automobiles, education, consumer durables, etc., it is almost impossible for the average working professional to avoid certain types of loans such as, housing loan, education loan, car loan, etc.

Today, thanks to advancements in fin-tech, access to a loan has become a lot easier than it was a decade back. Many leading banks and Non-Banking Financial Companies (NBFCs) now let you borrow money online for several needs. The primary advantage of availing of a loan online is that you get ready-to-use funds within a few minutes and from the comfort of your home. Moreover, with the online availability of loans, comparing different lenders has become surprisingly quick and easier.

Many individuals, especially those between the ages of 20-40 years, are falling into debt traps because loans (pre-approved, online) are so easy to avail of anytime. While fulfilling life goals and achieving financial goals are compelling and necessary, instant gratification is not. Therefore, if you are a potential borrower, evaluate if and why you need the finance and how much of it can be arranged from other sources in a way to minimize the debt quotient. Follow these 10 golden rules before applying for a loan to avoid taking on the wrong kind and creating a financial burden.

1. Do thorough research before applying:

Most borrowers, generally, do not check and compare the various available loan options and they instantly apply for a loan that their bank/lender offers. Before applying for a loan, thoroughly research all your options because loans are usually long-term commitments and this will save you from financial problems in the future. For example, if you are planning to renovate your house, instead of opting for a personal loan, explore the home refinancing option with your home loan as it generally has a lower interest rate compared to a personal loan. On the other hand, if a lender is offering a better deal on a personal loan than home loan refinancing, it would make sense to avail of a personal loan.

The comparison of different types of loans will help you to choose the right type of loan for yourself.

Once you have finalised the type of loan that is suitable for you, it is advisable to compare the rate of interest from different banks and Non-Banking Financial Companies (NBFCs). Bear in mind, a small difference in the rate of interest can make a substantial difference in the total loan outgo. A lower rate of interest will help you to make a wise decision to borrow the loan. Moreover, apart from the rate of interest, make sure you compare the processing fee, foreclosure charges, etc. as well.

2. Do not borrow more than your repayment capacity:

The old saying: “Do not borrow what you cannot repay” still stays true in today’s world. Many people make the mistake of opting for a large loan that later becomes a struggle to repay. Struggling to repay the existing loan can lead to taking another loan and the debt cycle continues. Doing this can disrupt your financial plan, drain your savings, and result in a debt trap. Although lenders generally check your repayment capacity, it is crucial to do it on your own as you might have other financial obligations for which you need to set money aside.

It is advisable to assess your income and repayment capacity while taking a loan and opt for a loan that you can easily repay. A general thumb rule is that your total EMIs should not be more than 40% of your net income. Having a debt-to-income ratio above 60% to 70% is an indicator that you could be falling into a debt trap. Hence, in such situations, you should avoid taking any further loans. To live a stress-free life, ensure your loan-to-income ratio is always maintained.

3. Check your credit score before applying:

A higher credit score lowers the rate of interest. A credit score is a three-digit number that shows your creditworthiness. When you apply for a loan, the bank or NBFC first checks whether you have a sufficient credit score to be eligible for a loan. If your credit score is less than 700-750 points, your loan application might not get approved. So check your credit score before applying for a loan to understand the negotiation leverage you have with lender.

Apart from the use of credit score for loan approval or rejection, it is an important factor that determines you get a lower rate of interest. Having an excellent credit score means you have a very good loan repayment history and your profile is less risky for the lenders to offer you loans. Therefore, applicants with an excellent credit score are generally offered a lower rate of interest compared to those with an average credit score.

If your credit score is insufficient to be eligible for a loan or if you want a loan at a lower rate of interest, then it is advisable to work on improving your credit score and then apply for a loan once it has improved. You can check your credit score directly with the credit bureaus or the various websites that offer credit score checks for free. Although it is not advisable to check your credit score repeatedly, checking your credit score once or twice a year, or before applying for a loan, to ensure there are no errors is a good practice. If you find any mistakes or errors in your credit score, you can get them corrected with a credit bureau.

4. Negotiate on Loan Terms:

There are some types of loans that you can avoid, such as education loans and home loans. Although the rates of interest on such loans are comparatively lower than other types of loans, the loan is usually huge and the tenure is typically longer. As the credit rule says, the longer the loan tenure, the more interest you have to pay. It is a good idea to minimise the loan tenure as much as you can to get rid of the debt earlier. If that is not possible, then try to negotiate the loan terms with the lender, particularly if you have a good credit score. If you have been an old customer of the bank/NGFC with good credit history with them, then they may consider your request.

5. Keep the loan tenure shorter:

The bank or NBFC representatives are likely to show you the lowest EMI calculation to attract potential borrowers. However, to make the EMIs look affordable, they increase the loan tenure. Always remember that the higher the loan tenure, the higher the interest outgo. Therefore, in order to save the interest outgo, it is essential to keep the loan tenure as short as possible. This way you can save a substantial amount on the interest component. Every penny saved is every penny earned.

6. Read the fine print of the loan agreement:

The loan agreement contains all the information related to the loan that a borrower must be aware of, including features, terms and conditions, rate of interest, processing fees, pre-payment charges, foreclosure charges, etc.. If you neglect to read the loan agreement beforehand, it can cost you dearly as some hidden terms and charges might not be in your favour. Therefore, make sure you read all the terms and conditions beforehand to make an informed decision and avoid any future disputes. If the loan agreement has clauses and terms that you do not understand, clarify and understand these with the lender before making a purchase decision.

7. Buy an insurance policy to cover your loan:

Life challenges us with uncertainty and unforeseen events can occur when we are least prepared. In case of the unfortunate demise of the borrower, unpaid loans can become a financial burden on the family. Therefore, to cover the loans, we advise you to buy a pure term plan equivalent to the loan. For instance, if your housing loan is Rs 70 lakhs, you should buy an additional term policy of the same amount, i.e. above your existing term plan. Covering your loans with a term plan will financially safeguard your family to clear the dues stress-free in your absence. They will be able to utilise your regular life insurance cover to continue living the same lifestyle.

8. Do not borrow to invest:

While personal loans are easy to get, it is certainly not advisable to invest the personal loan amount into high-risk securities like stocks; it can turn out to be the biggest financial blunder of your life. You can consider taking a personal loan for investments only if you are confident that your investment picks will actually generate much higher returns than the personal loan dues and do not have high risk stakes involved. Be cognizant of the risk level and have a backup source of income to repay your loan amount in case you do not earn sufficient returns. Moreover, ensure that you do thorough research and compare the personal loans offered by various banks and NBFCs to get the lowest possible rate of interest and processing fee to lower the cost of your loan.

9. Inform the family about the loan:

Taking a loan is a big financial decision that impacts your personal and household finances, informing the family about it is essential. To repay the loan quicker and reduce the debt burden, you can ask your spouse or family for financial help. If you pay a maximum down-payment for the loan, your dues will be lower and the loan becomes affordable. Moreover, if your spouse is earning, you can take a joint loan and share the loan repayment responsibility.

10. Make Timely Payments:

Prudent money management can lead to wealth creation, but not paying your EMIs or dues on time leads to debt accumulation. Besides, it can attract late payment charges and negatively impact your credit score. To avoid building up the interest component and penalties, make sure that you pay all the dues on time. If you are recklessly using your credit card/s, then you might get tempted to pay only the minimum amount due. Paying only the minimum amount will increase the interest component on the total amount due and you will end up paying a much higher amount. Therefore, it is essential to diligently pay dues in full. Also, check for old loans with higher rates of interest that qualify for prepayment or foreclosure.

Conclusion:

Taking on debt in the form of a loan can be advantageous when you want to improve your credit score and rebuild credit history, require money in an emergency/crisis, or to cover a shortfall in your down payment. Following these 10 golden rules before applying for a loan will help you save time and money, help fulfil your desires, and make debt work for you.

This article first appeared on PersonalFN here