What is a Personal Loan? How does it work?

We land into various situations where our needs exceed the size of our pockets. You might want to buy yourself a bigger house, or a bigger car or bring your dream vacation to reality. All these personal expenses need a huge amount of money, which you might not have with yourself at one given point in time. In such situations, personal loan comes to the rescue!

A personal loan is basically a fixed amount of money borrowed from a financial institution at a fixed rate of interest. This amount is borrowed at a condition of repaying the entire loan amount (called the principal amount) along with the interest amount at the end of the pre-decided loan duration.

According to the Reserve Bank of India, personal loans as of 2020 accounted for 28% of the total bank credit. With the increasing consumer demand for credit products, the volumes of new personal loan accounts observed a drastic increase of 133.9% in the third quarter of 2019, reports stated. Additionally, several studies also indicated that with the increasing volumes of personal loans, the inability of borrowers to repay their loans after the end of their moratorium period also increased; which eventually led to defaulters and lower credit scores.

Understanding Personal Loan

Here’s all you need to know about a personal loan-

  • Unlike credit cards or other forms of borrowing money, personal loans offer one-time payment of cash to the borrowers
  • The borrowed amount can be paid back to the lenders in the form of monthly installments over the course of loan duration, also known as the ‘term’
  • With the increasing demand for personal loans, it has become quite easy to apply for a loan and get approved for it
  • The loan approval process, however, may take up to one business week, depending upon the time taken by the lender in the processing of documents and other proofs
  • For the amount lent by the financial institutions, the borrowers are charged a fixed rate of interest on the loan amount (also known as the principal amount)
  • Apart from the interest, the borrowers may also have to bear other expenses such as the origination or administration fee
  • It is important to note that borrowers have the option of repaying their loan amount before their actual term. However, doing so, the borrower will have to pay an early payoff penalty for paying the loan before the actual loan duration
Read More: Personal Loan Charges: What You Need to Know

What are the Types of Personal Loan?

To get into the details, personal loans can be segregated into two categories-

  1. Secured personal loans- In case of a secured personal loan, the borrower has to provide a collateral in order to back up the personal loan. This implies that borrowers have to keep an asset with the lender as a security on the loan. If the borrower fails to repay the loan amount, then the lender has the right to seize the collateral (asset/security). The idea of a collateral reduces the lender’s risk; hence, it becomes easier to borrow a secured loan.
  1. Unsecured personal loans- In most cases, personal loans are unsecured. This means that borrowing a personal loan does not necessarily require the borrower to offer a collateral. Since no security is asked for, in exchange for the loan amount, the lenders keep a close check on factors like credit history, monthly/annual income, outstanding debits, credit score, etc. while evaluating the potential borrower. With a bad credit history, getting approved for an unsecured personal loan can be pretty difficult.

Irrespective of their types, all personal loans work in the same way. The application, approval and repayment process vary depending on the bank’s terms and conditions and not the type of personal loan that you are applying for.

How does a Personal Loan work?

If you ever need to apply for a personal loan, the below mentioned steps explain how a personal loan works-

  • After you have figured out that you need to borrow a personal loan to meet your personal expenses, you must also under whether or not you are willing to borrow a secured or unsecured personal loan
  • After making this choice, you are advised to do a thorough research on the personal loan interest rates and other related terms and conditions on personal loans offered by various financial institutions
  • Post this, you need to check if you meet all the personal loan eligibility conditions. If you do, you may move ahead and fill out an application form for the same
  • After submitting the application and other relevant documents, your application will be verified on the basis of your cre, credit score, your income, etc.
  • Upon successful completion of the verification process, you will receive a notification regarding the status of your application
  • The amount will then be transferred to your loan account and you can begin to enjoy the benefits
  • It is important to note that once you borrow a personal loan, you will mandatorily have to pay all your monthly installments along with the specified rate of interest

Benefits of Borrowing a Personal Loan

There are some absolute reasons why you should opt for a personal loan instead of other borrowing options. We have listed down a few of them for you-

  • Personal loans are flexible and versatile. Unlike other loans which can be used only for pre-specified purposes, personal loans can be used for multiple purposes. From consolidation of debts to paying off medical bills- personal loans can fulfill all your personal financial needs. Additionally, if you are looking to finance a big purchase, but don’t want to be restricted by how and where you use the borrowed amount, then a personal loan would be a good choice.
  • Personal loans charge a low interest rate. In comparison to credit cards or other financial instruments that lend money, personal loans charge a low interest rate.
  • Personal loans offer high borrowing limits. If you have managed to maintain a good credit history and have a credit score of 650 or more, then you can apply and eventually, get approved for a higher loan amount at lesser interest rates.
  • Personal loans do not require collaterals. Most personal loans are unsecured; hence, they do not require the borrower to pledge any security with the lenders. However, in case of unsecured personal loans, if the borrower fails to repay the borrowed amount within the specified time period, then he/she may have to face major financial consequences.
  • Personal loans are relatively easier to manage. In comparison with multiple other financial borrowing instruments, personal loans are pretty easy to manage. Instead of handling multiple credit card accounts, borrowers can consolidate their debt by borrowing a single personal loan which will eventually fulfill all their personal financial needs and will be easy to repay at the same time.

Risks of Borrowing a Personal Loan

While personal loans can be the preferred choice for many, they may not be a suitable borrowing option for some. Here’s why-

  • Personal loans may charge relatively high interest rates. In comparison with various other options, the interest rate on personal loans may not always be the lowest. For borrowers having a poor credit history, this may be an important factor for consideration.
  • Expenses penalties and on personal loans can be very high. Personal loans come with various additional expenses that you may not be aware of, in the beginning. These expenses eventually add up to the cost of borrowing. Additionally, certain lenders also charge a fee on prepayment of the loan amount before the fixed tenure. Hence, it is advised to review all the additional fees and penalties before applying for a personal loan.
  • Fixed, monthly installments are mandatory in personal loans. Unlike credit cards, that allow you to pay a minimum amount instead of the entire monthly credit card bill, personal loans make it mandatory for the borrowers to pay the fixed monthly installment in full.

FAQs
What is a personal loan?
A personal loan is a fixed amount of money borrowed from a financial institution for the purpose of meeting all the personal expenses. This amount is borrowed from the lender at a fixed rate of interest, and for a pre-defined time period.
Are there any risks associated with personal loans?
Yes, there are a few risks/drawbacks of borrowing a personal loan. These include high interest rates in comparison to other financial instruments, additional expenses, penalties on pre-payment of the loan amount, etc.
Are there any personal loan eligibility conditions?
Yes, there are a few personal loan eligibility conditions such as borrower’s credit history, credit score, salary, current debts, etc.
What is a personal loan EMI calculator?
A personal loan EMI calculator is a tool that allows you to calculate your monthly installments on the loan amount. To calculate your EMI through the personal loan EMI calculator, you need to enter your loan amount, loan term and the rate of interest on your loan.
What are personal loan interest rates?
Personal loan interest rates vary from bank to bank. The interest rate also depends on the amount of loan and the time period for which the loan is being borrowed. The personal loan interest rates for the current year vary between 9% to 11% per annum.
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