What is a personal loan, and how does it work?
Often we are stuck in deciding between a bank or a credit card to take a loan. The former allows you to take only for specific purposes, whereas the latter comes with high-interest rates. But there is a viable third option: a personal loan that can come in handy during unprecedented situations.
A personal loan can generally cover most of your expenses and is easier to apply for.
Because of its quick disbursement and flexible application process, personal loans have become the personal choice of many in recent days during financial difficulties.
What is a personal loan?
A Personal loan is a large sum of money that can be borrowed without putting up any collateral or specific purpose.
For instance, if you have a medical emergency or plan to have a big wedding and your funds have already been used to pay off other debts, personal loans come to your rescue.
They come at lower interest rates and can be paid in periodic installments over a fixed period. The loan tenure can range from 1 month to 60 months based on how you want it.
Unlike other installment loans like car loans or home loans which can be taken only for a specific purpose, personal loans can be taken for anything.
Here is the catch: It can be used for paying off consolidated debts and streamlining into one debt instead of many.
Expenses that a personal loan can cover
A personal loan can essentially be used to pay both your personal and professional expenses.
You can use a personal loan to cover:
- Medical expenses
- To pay off higher debt
- Wedding expenses
- Vacation expenses
- Finance for your business
- Relocation expenses
Don’t confuse a personal loan with a personal line of credit
Although a personal loan and a personal line of credit sound familiar, they are not related to one another. A personal loan lets you take a large lump of money, and the process ends as and when you finish the repayment.
On the other hand, a personal line of credit works like a credit card. You can use funds up to your maximum limits and can restart the process all over again after refilling the credit line.
To better understand it, imagine you are planning on revamping your home interiors, and you are unsure about the expenses. A personal line of credit can be claimed here since it allows you to borrow money without any limit. Whereas with a personal loan, you need to be clear about how much you need to borrow.
Though both personal loans and personal lines of credit have interest rates, a personal line of credit can be charging you a higher interest rate depending on how much you are spending. But, as opposed to a personal loan, if you take a personal line of credit, you can start paying interest only after using the funds and not as soon as your loan is approved.
Types of personal loan
A personal loan is of two types:
1. Secured loan
Here, the borrower has to give collateral for the loan. Be it a savings account, fixed deposit certificate, or a physical asset like a belonging( car, house, etc.).
A borrower failing to repay the secured loan has to give up the collateral to balance the debt.
The mortgage is an example of a secured loan.
2. Unsecured loan
Unsecured loans do not need any collateral. They are a little risky to the lenders and can cost you higher interest than a secured loan. Needless to say, there may be repercussions if you default on an unsecured loan. The lender can file a lawsuit, decreasing your credit score, hampering your future loan requests.
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Unsecured personal loans work best for bigger expenses like a wedding or a grand vacation.
How does a personal loan work?
Let us break down the process into tiny bits for understanding.
- The very first step to taking a personal loan is to apply to a lender. A lender can be a bank or any NBFC (Non-banking financial company).
- Make a thorough research on different options by comparing parameters like application process, disbursement, and interest rates and fill out the forms.
- The lenders follow their own stringent set of rules to check your credit score, salary and run other background checks before approving the loan. Using Fintech startups like Money view, you can be one step ahead by checking your eligibility within 2 minutes using their online app.
- Once your application is approved by the lender, your money will be transferred to your bank account within 48 hours to one week, depending on the lender you choose.
You might choose to get a cheque too instead of a direct transfer. In some cases where you have consolidated debts, the lender will offer to pay the creditors without your involvement.
- Once you get the money, use the fund for any purpose that you like. But it is advisable to start the repayment within 30 days and make timely payment to avoid any penalty from the lender.
- You can repay the loan via any online payment method like NEFT or post-dated cheques.
How to calculate the interest for a personal loan?
As said earlier, lenders consider various factors like your salary, credit score, and other debts you owe to provide you the ROI on the personal loan. The longer the tenure you opt for, the higher the interest rate. So, if it’s in your capacity, choose a short tenure to avail yourself of the benefit of a low rate of interest.
You can calculate the interest amount manually using the two methods given below.
1. Flat rate method:
The interest is fixed throughout the tenure and charged based on the principal amount borrowed.
The formula used here is:
Total Interest payable =
(Principal*Rate of Interest per annum*Tenure in years).
Total EMI payable per installment = (Principal+Total interest payable)/Repayment period in months.
2. Reducing balance method:
Here, the principal amount decreases. The interest paid is revised every month based on the outstanding loan amount.
The formula used for this method is EMI = [P x R x (1+R) ^N]/ [(1+R) ^N-1]
Where P is the principal amount. R is the rate of interest, and N is the loan tenure.
However, an easier and more convenient method is to use an online Personal EMI calculator. For instance, Money View provides you instantly the interest amount to be paid with their online service. All you need to give is the principal amount, rate on interest, the loan tenure, and Bam! They have it done for you.
Where to get a personal loan and other factors
There are many options to get a personal loan. One golden rule is to maintain an excellent credit score and keep all your EMIs duly paid to be an ideal borrower.
You can visit your current bank or rely on credit cards to apply for a personal loan. Remember, every lender has its system, and the funds will be directed within a week, depending on the time they take to make a background check.
But in recent days, the online method has taken a ruling hand as they provide quick loans at low interest and with minimum hassle. Money view is one such online app with an easy application process, online eligibility check, and funds transferred within a few minutes.
Nonetheless, keep in mind that, like every loan, a personal loan also comes with some risks.
- Since they are unsecured loans, personal loans may come at higher interest rates.
- And if you want to prepay the loan, some lenders may charge a prepayment penalty, so make sure you repay in the given duration.
- Some lenders also charge a processing fee and loan initiation fee in the application.
- There are instances where some lenders also hesitate to give a personal loan owing to another larger debt that you have, fearing that you cannot repay this loan.
Today, we have many options to take a personal loan. However, do your research and make a rough estimate of how much money you need and whether it is an emergency. Go through the process of multiple financial institutions and choose what is best for your financial situation.