What are personal loans and how do they work?

Are you dreaming of visiting your favourite country but finding yourself short on funds? Or perhaps you're eyeing a luxury gift or need quick cash for miscellaneous expenses? A personal loan might be the solution you’re looking for! While personal loans are a popular choice for many, it’s crucial to understand whether this option is right for you before making any commitments.

How do personal loans work?

Personal loans primarily depend on your credit score, financial status, and current market conditions. To obtain a personal loan, you must adhere to specific guidelines and meet the eligibility criteria set by the lending institution. 

If you qualify, the bank will provide you with an interest rate based on several factors, which will determine how you repay the loan. Here’s a step-by-step breakdown of the personal loan process:

1. Application process

After selecting the bank from which you wish to secure a personal loan, you need to begin the application process. This involves understanding and fulfilling the required formalities.

2. Document submission

Once you’ve applied, the next step is completing the KYC (Know Your Customer) process. This requires submitting essential documents, such as proof of identity, address verification, income statements, and your PAN card. Check with your bank for the specific documents they require.

3. Application review

After submitting your documents, the bank will review your application, which typically takes around 5-7 business days. If you meet their eligibility criteria, your personal loan will be approved.

4. Loan disbursement

Upon approval, the loan amount will be transferred to your bank account. While many banks transfer the funds instantly, some may take up to 24 hours.

5. Loan repayment

You are required to repay the personal loan within the specified tenure. The bank will charge you an interest rate based on various factors, and you’ll need to make repayments on a monthly or yearly basis, depending on the bank's terms.

6. Early repayment options

Many banks allow you to repay your personal loan ahead of schedule or to foreclose it. However, be aware that some banks may impose a pre-closure fee, so it’s wise to check this in advance to avoid any unexpected costs.

Factors determining your personal loan EMI

You might be wondering how the Equated Monthly Instalment (EMI) is calculated for your personal loan. These three factors play a role in determining the EMI amount:

• Principal amount: A larger loan amount typically results in higher interest costs and EMIs. Your loan approval will largely depend on your financial stability and the loan tenure you choose.
• Loan tenure: Opting for a longer repayment period can lower your EMIs, but it may also result in paying more in total interest over the life of the loan.
• Interest rate: The interest rate reflects the cost of borrowing, expressed as a percentage. Factors such as your credit score and prevailing market conditions will influence the rate. A lower interest rate can make your EMIs more manageable and reduce the overall financial burden.

How to calculate interest rate for personal loan?

Interest rates vary by bank, but they are usually calculated using a simple formula:

For annual interest calculation,

Annual Interest =12P×R×T​

Where:

• P = Principal amount
• R = Rate of interest
• T = Duration in years

This means that the monthly interest can be calculated as:

For monthly interest calculation,

Monthly interest = PXRXT/12

Let’s consider an example with a loan amount of ₹12 lakh and an interest rate of 11%.

1. Loan Amount: ₹12,00,000
2. Rate of Interest: 11%

Annual Interest Calculation: 11/100 X 12,00,000= 1,32,000

Monthly Interest Calculation: 1,32,000/12 = 11,000

Thus, the interest added to the EMI will be ₹11,000.

Eligibility criteria for a personal loan

While different banks may have varying eligibility criteria, here are some common factors you need to consider:

• Age: Generally, you must be at least 21 years old when applying and no more than 60 years old when repaying the loan. This can vary by bank.
• Employment: Proof of stable employment with a reputable company is often required. Self-employed individuals should provide evidence of consistent revenue.
• Credit score: A good credit score demonstrates financial stability and can help you secure lower interest rates. Banks typically prefer a CIBIL score of 750 or higher.

Ultimately, the bank holds the discretion to approve your personal loan application.

Is a personal loan right for you?

Personal loans can be an excellent option for many, but it’s important to note that they often come with high interest rates, which can strain your finances if not managed properly. Always read the terms carefully before signing any documents, and consider taking out a personal loan only if you genuinely need it.

Avoid large amounts or long tenures, especially if you already have existing loans, as this could complicate your financial situation. Being mindful of your choices can help you prevent regrets in the future, as personal loans represent a long-term commitment.