What are the key factors that affect personal loan interest rates?

India’s household savings as a proportion of our GDP is declining. In its latest Financial Stability Report (June 2024), the Reserve Bank of India has also noted that while net financial savings have declined in 2022-23, financial liabilities have gone up thanks to retail loans for consumption and investment.

Rise of personal loans

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

The lure of personal loans isn’t without reason. These are flexible loans, the funds from which can be used for any purpose, they don’t require a collateral and there is minimum documentation needed. Some lenders will give out these loans which can be topped up too.

So, you can essentially borrow anywhere between ₹30,000 to ₹50 lakhs without much time or effort invested. Tenures of these loans can vary but typically the borrowing is for a minimum of 12 months and prepayment in that period is not allowed.

There are hefty pre payments charges where you are allowed to repay the loan before a year is up. All said and done, when you need money for a substantial spend, personal loans are the low hanging fruit you can reach out and pluck to satisfy your needs.

While the process itself is simple, these loans do come with a relatively higher interest rate and the lender can adjust the rate depending on who the borrower is. Typically, large sized banks will have a minimum interest rate offered at 10.5% -11% per annum, but for small sized banks and non-banking lenders, the interest rates can be upwards of 11.5%-12% per annum.

The catch is that the maximum interest rate can go up as high as 25%-30% per annum or more. So, not only is it critical for you to clearly understand the interest rate you are getting before you sign the documents, but also you must try out everything you can to optimise the interest rate offered to you by the bank or the non-banking lender.

Importance of credit scores

Ironically, one of the most important factors for determining the interest rate you will be offered for a personal loan, is your credit score. Your credit score depends on your total debt availed in the past 7-8 years and your timeliness in servicing this debt or paying your instalments on time. Even things like credit card payment matter. However, if you don’t use a credit card or have never taken a loan from any institution, you will be at a disadvantage.

So, if you are someone who has never taken out a loan or used a credit card, it’s unlikely that the rate offered to you will be the most favourable, although intuitively one assumes that’s how it should be. The issue is that the lender has zero data with which to analyse you as a loan customer, whether you are responsible with your repayments or not is important for the lender and they have nothing to verify this aspect or any other data on your behaviour as a borrower. Your credit score captures your repayment discipline, any defaults and any other lending related behaviour for your past loans and credit card payments in one place. This is very useful for the lender.

You might think, if so far, you have never taken a loan, why bother now with the credit score? Let’s say you have a medical emergency in the family and you have no other resort but to take on a personal loan to pay the dues. If you are uninitiated in the world of debt, you will most likely find it a harder process to get the loan in the first place and the interest rate will not be the most optimum either. Thus, it may be in your favour, in anticipation of future need for loans, to sign up for a credit card which is a simple form of borrowing that you can use instantly.

Ideally, you need a credit score upwards of 730 for a favourable interest rate. A very low score, say something below 600 may even make you ineligible for a personal loan from some lenders and will definitely make the interest rate offered shoot up.

Other than your credit score, be mindful of your current debt servicing. This refers to the total debt repayment you are making today from your monthly income, the higher this ratio, the higher will be the interest rate offered to you. Too many loans at one time risk your ability to repay the next one on time too. Your employment history and regularity of income is also a big factor that the lender will be interested in while deciding whether to give you a loan or not, how much to lend and at what rate. This one is obvious; a steady income from a steady job is an advantage. Other simple things like your age, number of dependents and purpose of the loan can be determinants in setting the final rate offered.

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

For those who manage their money well, personal loans will always be easy to come by, even if the need is not there. If you do find yourself in a position where you need one, just know that to optimise the cost and the conditions that the lender gives you the loan on, you do need to display some discipline in your recent financial transactions and in your income. Most importantly, you need to have some debt history for 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