What are the main factors that influence interest rates on personal loans?

Indian household savings as a percentage of our GDP are declining. In its latest Financial Stability Report (June 2024), the Reserve Bank of India also noted that while net financial savings have declined over 2022-2023, financial liabilities have increased on the back of private loans for consumption and investment.

Rise of personal loans

The personal loan portfolio of mainstream commercial banks saw an increase of 21% in 2022-23 and around 27.5% in 2023-24. It is clear that individuals are spending more and doing so with the help of loans.

The appeal of personal loans is not without reason. These are flexible loans where the money can be used for any purpose, require no collateral and require minimal documentation. Some lenders provide these loans, which can also be supplemented.

So in principle you can borrow from anywhere ₹30,000 to ₹50 lakhs without investing much time or effort. The term of these loans can vary, but the loan usually has a term of at least twelve months and prepayment during that period is not permitted.

There are high costs for prepayments where you may repay the loan within one year. All said and done, if you need money for a substantial expense, personal loans are the low-hanging fruit that you can use and pick to meet your needs.

Although the process itself is simple, these loans have a relatively higher interest rate and the lender can adjust the interest rate depending on who the borrower is. Typically, for large banks, a minimum interest rate of 10.5%-11% per annum is offered, but for small banks and non-bank lenders, interest rates can go up to 11.5%-12% per annum.

The catch is that the maximum interest rate can be as high as 25%-30% per year or more. So not only is it crucial that you fully understand what interest rate you will be getting before signing the documents, but you should also try everything you can to optimize the interest rate offered to you by the bank or non-bank lender. .

Importance of credit scores

Ironically, your credit score is one of the most important factors in determining the interest rate you’ll be offered on a personal loan. Your credit score depends on your total debts accrued over the past 7-8 years and your timeliness in repaying these debts or paying your installments on time. Even things like credit card payments matter. However, if you don’t use a credit card or have never taken out a loan from an institution, you are at a disadvantage.

So if you’re someone who’s never taken out a loan or used a credit card, it’s unlikely that the rate you’re offered will be the most favorable, even though you intuitively assume it should be. The problem is that the lender has no data with which to analyze you as a loan customer. Whether you are responsible for your repayments or not is important to the lender, and they have nothing to verify this aspect or any other data about your behavior as a lender. borrower. Your credit score records your repayment discipline, any defaults, and other credit-related behaviors for your past loans and credit card payments in one place. This is very useful for the lender.

You may be thinking, if you’ve never taken out a loan before, why worry about credit score now? Suppose you have a medical emergency in the family and you have no other solution but to take a personal loan to pay the dues. If you are not initiated into the world of debt, you will probably find it more difficult to get the loan in the first place and the interest rate will not be the most optimal either. So it may be to your advantage, in anticipation of future loan needs, to sign up for a credit card, a simple form of borrowing that you can use immediately.

Ideally, you need a credit score above 730 for a favorable interest rate. A very low score, say just under 600, may even make you ineligible for a personal loan from some lenders and will certainly increase the interest rate offered.

Aside from your credit score, consider your current debt repayments. This refers to the total debt repayment you make today from your monthly income. The higher this ratio, the higher the interest rate you will be offered. Too many loans at once carries the risk that you will not be able to repay the next loan on time. Your employment history and the regularity of your income are also a big factor that the lender will be interested in when deciding whether or not to give you a loan, how much to lend and at what rate. This one is obvious; a fixed income from a permanent job is an advantage. Other simple things such as your age, number of dependents and the purpose of the loan can go a long way in determining the final rate offered.

It helps to have a good banking relationship with your main bank. If you are carrying balances, have fixed deposits, an insurance policy and a credit card issued through them, you are probably already receiving messages and emails for pre-approved personal loans available to you at the best price.

For those who manage their money well, personal loans will always be easy to obtain, even when the need is not there. If you are in a position where you need one, know that in order to optimize the costs and the conditions under which the lender gives you the loan, you must show some discipline in your recent financial transactions and in your income. Most importantly, you need to have some debt history to get a decent credit score before you can ask for the best deal on the next loan.

Lisa Pallavi Barbora is a financial coach and founder of moneypuzzle.in