Short Term Personal Loans – To take or Not?

After the recent fall in stock markets, I have (once again) started getting emails asking whether it makes sense to take a loan and invest now. 🙂

This isn’t surprising. Whenever markets start falling or remain subdued for some time, I start getting similar emails from ultra-aggressive investors.

And as if its Loan God’s wish, it’s pretty common these days to get unsolicited mailers in your inbox about pre-approved loans. To be honest, the idea seems tempting to take the loan and invest it. But I don’t do that. Borrowing to invest in volatile assets like equity is extremely risky. In fact, it’s a recipe for many stories of financial disasters.

Now before I simply brush aside the idea of investing on borrowed funds, let me also say that the idea of borrowing to invest itself is not bad. It is just a very risky one and not suitable for most investors. Most people who are attracted to it don’t really understand the dynamics of it.

So I strongly urge you to stay away from investing with borrowed money.

It is easy to get lured by the charm of earning handsome returns doing that. But equity markets don’t move in a straight line and more importantly, don’t deliver returns on demand. They have a mind of their own.

So there is no guarantee that you will get profits. On the other hand, loans are fairly predictable. You have to repay your personal loans without fail and on time. 🙂

To put it more aptly, there is a sheer mismatch in the common tenure of personal loans (short term) versus suitable tenures that are needed to ensure good returns from equity (long term).

For the majority of people (and I am repeating) – they shouldn’t borrow and invest in equity markets.

If you really want to build wealth, it’s better to take the gradual and stable route – invest in well-diversified equity funds via monthly SIPs towards your financial goals. That’s a far surer way to accumulate wealth in the long term.

So with that aside, let’s get to the question about what should the short-term Personal Loans be taken for?

Again, it’s easy for me to say that you should not take personal loans and you should plan for your money needs in advance. For obvious reasons, nobody would borrow money if they could avoid it. Isn’t it? But life has its knack of surprising us.

People will have unexpected needs and emergencies and they will take loans.

If you need the money and don’t have it, then depending on how comfortable you are, chances are that you might first ask your friends or family to lend you some money. In most cases, they won’t even charge any interest. But many people aren’t comfortable doing that. The next option is the loans.

So let’s see what all factors should be considered before you take that short-term personal loan:

Important things to consider before taking Short Term Loans

1) Getting a Low Personal Loan Interest Rates

I know – the first question that comes to mind of borrowers (after thinking how are they going to repay it) is how to get the Lowest Interest Rate on Personal Loan?

This is actually a no-brainer. Lower the loan rates, better it is for you.

But at times, you may even have to accept higher rates if the loan amount you need is available from a lender who is charging slightly higher.

Now here is an important thing. When making the decision, don’t just look at the interest rate being offered. There are other things to consider too. Do read the fine print or ask the lender whether the loan is being given on a flat-rate basis or a reducing-balance basis. This is one thing. Another is that the interest cost is not the only cost that you have to pay. There are other charges like Processing Fee (Lower the better) Prepayment Fee (again lower the better) Late Payment Fee (any guesses?)

So basically, the total landed cost of the loan (which is not just about the loan rate) should be the minimum for you.

Now personal loans are unsecured loans. That is, they don’t take any security from the borrowers. So naturally, the rates will be high. But if it’s possible for you to provide some security (like LIC policies, precious metals, other savings, etc.) and make it a fully or partially secured loan, then the lender would very easily reduce the loan interest rate by few percentage points. And that can help you a lot.

2) Getting the Optimal Loan Amount

If you need a personal loan for a specific reason, you would already know how much money you need.

But what happens is that lenders try to entice borrowers to borrow more than what they actually need.

Please don’t do that.

Just because you can avail a bigger loan, don’t go overboard. Take a loan of as small an amount as possible. If you need a loan of Rs 2 lac, then take a loan of Rs 2 lac or lower even if someone is willing to lend you Rs 5 lac.

A loan is a loan and you need to pay interest for what you borrow. And you don’t want to pay interest on the money you don’t need.

3) Loan EMI and Tenure

The maths of personal loans (or any loan) is such that the tenure selected along with the loan amount and the interest rate determines your final EMI.

How much EMI you should opt for?

To be honest, you yourself are the best judge. No one knows about your repayment ability better than you. But your income is limited and with regular expenses to take care off, there is a limit to how big EMI(s) you can afford. EMIs have to be paid month-on-month and without fail. It’s not an option but an obligation.

Do an honest assessment and chose the EMI which is affordable and comfortable for you to manage during the full loan tenor and not just initially.

So first find out what EMI you can comfortably manage first. And then manipulate the loan tenure and/or the loan amount to arrive at an EMI that is affordable for you. There are several free personal loan EMI calculators available online. Try them out. These loan calculators not only show the loan EMI but also tell you the total loan interest payable throughout the loan tenure.

And if you feel that the lowest EMI is the best one possible for you, then let me tell you that it may be comfortable but it is not the best.

Ideally, you should try to keep the repayment period as short as possible. The reason is that it will reduce your total interest burden during the loan tenor.

Although your EMIs for a short-tenor loan would be higher than a longer-tenure loan, it makes mathematical sense to reduce your total interest outgo. Here is a small example to help you understand this – Suppose you avail a personal loan of Rs 5 lakh at an interest rate of 16%. Then your total interest paid over the loan tenor would be as following:

• 5-year Tenor – Rs 2.29 lakh
• 4-year Tenor – Rs 1.80 lakh
• 3-year Tenor – Rs 1.32 lakh

Ofcourse, you need to consider EMI affordability too, which changes with loan tenor:

• 5-year Tenor – EMI of Rs 12,159
• 4-year Tenor – EMI of Rs 14,170
• 3-year Tenor – EMI of Rs 17,579

But I hope you understand what I am saying. If you can increase your EMI a bit, you can easily save a lot of money on interest. I did a similar analysis for home loans. You can read how shorter loan tenor reduces total interest outgo for home loans.

Once you have taken a short-term personal loan, you need to understand that you should regularly pay your EMIs. It’s not just because lenders want you to do that. It is also because your credit score can be improved by smart repayment of these short-term personal loans.

The credit score is used by lenders to evaluate your capacity to pay the loan on time. In general, higher your credit score is, the better chances you have of loan approvals. So how does a personal loan help improve credit score? When you take a small loan, it’s easier to repay than a large loan. So you can easily pay off all your EMIs on time (remember always go for affordable EMIs to ensure this). Once you do that, it incrementally improves your credit score.

And I don’t need to tell you why having good credit or cibil score is important. Sooner or later, you will take big loans – like a housing loan.

At that time, lenders will check your credit score and history. So having a good score will work in your favor and increase the chances of loan approval. And as things are expected to pan out, the borrowers with a higher score will get loans at slightly lower rates than those who have a lower credit score. This in itself means that one can save a lot of money in lower interests.

For example – suppose borrower A and B both need Rs 75 lac home loan. Due to a higher credit score, the bank is offering a home loan to A at 9%. Whereas the same loan is being offered to B at 9.5%.

Can you guess what is the cost of this difference over the course of the loan (assuming 25 years)? The total additional interest paid by B will be about Rs 7.5 lac.

So having a high credit score when you are taking bigger loans can save you a lot of money. If you do not have any credit history, then you can even consider taking a credit card against a fixed deposit and build up your credit score slowly.

Enough said…

I said this earlier and will repeat it again – it’s easy for me to write here that one shouldn’t take personal loans. But practically speaking, people will need to borrow and they will. So might as well be smart about it and manage the personal loans well.

If loans are taken for genuine unplanned emergencies, then its fine and make sure that you do consider interest rates, charges and convenience. But do not borrow to invest in stocks. Please don’t do it. 🙂