Before taking a loan
The ultimate objective is to get the least expensive loan with fewest of restrictions. Yet achieving these objectives is not easy.
Why is deciding on a cheap loan not easy?
Lenders are super cautious in dealing with borrowers since the first caveman loaned a spear to a friend only to have it returned in little pieces. Moreover, lenders know they have a certain power over borrowers and have turned terms and conditions into a mystery or some secret power which reveals itself in times of distress.
We take a very informed decision before taking a loan of any kind to avoid such situations. Yet we get shocked by the terms and conditions when paying EMIs becomes difficult. It happens to most of us because of the fine print. The reason for the shock is either lack of understanding the terms of loans or shying away from understanding all of it because finance is complex. But most likely, no one prepares to default on a loan so we assume that we’ll remain untouched by those incomprehensible terms.
One can decide one’s own eligibility and the best-loan-fit by easily understanding the definition of a handful of terms and how & when it applies in the life of a loan. Although the list may appear long, I’ve tried explaining in a simple language.
What to look for before finalising a personal loan?
Loan Amount: Before deciding the loan amount, please be very clear with yourself of the reason for borrowing. Just because you are not meeting monthly expenses because of other luxuries is a recipe for defaulting on a loan. On the other hand, it’s cheaper to take a personal loan and repay a credit card debt.
Monthly payment: This might sound very simple but it is the unit economics of borrowing. Write your income and all of your frequent (monthly, quarterly, and yearly) expenses. Include mortgage or rent, premiums, utilities, food and other debts. Subtract your expenses from your income. Using that figure, determine a realistic amount you can pay EMIs to the lending company.
Note: Future is uncertain. Being less optimistic about future is better preparation. Hence, do not include any hypothetical income in the future. e.g. promotions, salary hikes, income from sources not identified today, etc.
APR: It is Annualised Percentage Rate. If you understand APR, then you will avoid one of the biggest traps of the accruing interest rate. APR is the annual percentage rate expressed over the term of the loan. APR of a payday loan at 0.5% per day is 182.5%; APR of credit card dues at 3.46% per month is 41.52%. That’s why it is advised to repay credit card dues and payday loans in time. Non-payment of these dues is one of the top three reasons of poverty along with lack of health insurance and lottery.
TIP: Ensure you know APR before you sign any agreement.
Loan Term: How long you have to repay what you borrowed. Loan repayments are broken down into a schedule that shows the breakdown of the balance in the following manner:
- Principal
- Interest
- Principal decreasing over time
- Total interest paid
The schedule is also known as an amortisation schedule. e.g. Following is a schedule for a loan amount of Rs.1,00,000.00 at 18% per annum for a tenure of 36 months.
TIP: The longer your loan repayment period, the lower your monthly payment, but a longer loan repayment period can also translate to more interest paid in total over the life of a loan. You may use this as a loan calculator to determine how a shorter loan tenure can affect the cost of a loan.
You may duplicate the table and play with the amount, interest rate and months (all text in blue background).
Fees & Penalty: Annualised percentage rate tells us about the annual cost of the loan. While there are fees and penalty that could further affect your decision.
- Application fee: Sometimes lenders want to save time by screening serious borrowers only. So they charge an application fee.
- Origination fee: This is a processing fee after loan application. Often associated with mortgages.
- Closing fees: This is also often associated with asset-backed lending where the lender charges you for processing return of your assets.
- Prepayment penalty: When you decide to close or prepay loans before schedule, lenders charge you a percentage (~2–5%) of the outstanding amount for disturbing their future cashflows.
- Cheque/ ACH Swapping Fee: If you wish to swap the cheque or bank account from which EMIs are deducted then lenders will charge a fee.
Fixed or floating interest: Your loans could be charged either at a fixed or floating rate. If you have a choice, then you must check the difference in rates. A floating rate gets its interest rate adjusted often with market conditions. This can be good or bad. Floating interest rates are usually set 1% to 2.5% lower than the fixed interest rate offered by the same lender. In case the floating interest rate exceeds the interest rate, it will not be for the entire loan tenure. There are chances that the floating rates might come down after a certain period of time.
Unsecured or secured loan: A secured loan is when you have to back it up with collateral. A lender may ask for collateral when your demand is higher than you deserve or you do not have sufficient credit score. An unsecured loan does not require you to back it up with any collateral.
Back it up with an asset: Even if you are opting for an unsecured loan, it is a good practice to prepare yourself how you are going to repay in the event you default. What is obvious today may be doubtful tomorrow. This is the time to use your tangible or non-tangible assets such as MFs, Gold, property, etc to square-off your liabilities. Backing up is mental preparation for the worst.
Automatic Withdrawal: Please check whether automatic withdrawals of EMIs are mandatory or optional. If optional, will you get a lower interest rate if you agree to automatic withdrawals? Ideally, lenders will take your mandate for automatic withdrawal to avoid delayed payments. Please ensure that the upper limit is not more than the monthly payment in your mandate.
Arbitration: Arbitration comes in handy in the event of a conflict. You have to check if arbitration is mandatory. Or, is there a provision to take it to the court of law.
Credit score: Last, but not least, please check your credit score before applying for a loan. If it is low, please work on it. Sometimes a loan might be pending or previous loan payments might not be updated. You can work with the lender to resolve it. Credit score will play a crucial role in determining the cost of the loan. A lender might charge you a higher rate of interest for a low credit score.
Loan rescheduling fee: Considering the impact of pandemic and moratorium availed, there are many borrowers who would have requested for rescheduling of loans. Banks charge a fee to examine the reason for non-performing. If it is found from such review that the borrower has diverted the funds elsewhere or the borrower is a habitual loan defaulter the lender shall not consider the application for loan rescheduling. Instead, the lender shall take/continue all legal steps for recovery of the loans.
Loan cancellation charges: When you buy a product with a loan but it is not delivered to you either due to non-availability or due to a defective piece or any act that renders the delivery of the product impossible, you have the option to cancel the loan. Lenders may charge you for cancelling the loan.
When you are able to speak in a banker’s language, you become more confident in talking to lenders. I hope you are now better equipped to negotiate and read the fine print of a loan. In case you want to enquire about other specific terms and conditions of the loan. Please leave a comment below and I will answer all of it.
