Personal loans are an easy way to arrange for funds to meet any shortfall during the course of your life. They can be taken for any purpose you want, be it buying a big ticket item, funding education, going on family vacation, renovating a house, meeting wedding expenses or for a medical treatment. These days people are increasingly taking personal loans to consolidate their debts and pay off high interest credit card balances. Since the risk exposure in case of unsecured personal loans is high, they are usually provided on the basis of a person’s credit worthiness. A good credit score is a sign of responsible behaviour and therefore helps in winning the trust of the lender. But these days several private lenders also offer personal loans for low CIBIL score to people who have had a bad shot with their credit history.
These unsecured loans may seem pretty harmless, but there are several risks associated with them. Also if these loans aren’t managed well from the beginning then one stands a risk of falling into a debt trap. Let’s look at some of the risks of unsecured personal loans.
Loan amount- The amount that one can borrow through an unsecured personal loan is generally lower than what one can qualify on a secured loan. Since the risk of losing the principal amount is high in case of unsecured loans, lenders limit this risk by offering smaller loan amounts. So in case you need funds for bigger expenditures, unsecured loans cannot be relied upon to meet the payment obligations.
Prepayment penalty- It is in the interest of the lender that you continue your loan for the entire tenure that is fixed initially. Though you can prepay your loan, most banks charge a prepayment penalty to discourage such actions by the borrower. If you end up paying interest for the entire tenure of the loan, then prepayment will turn out to be quite expensive. If you plan to pay off your loan as soon as you can arrange for funds, then read the terms and conditions carefully before signing up for the loan.
High interest rate- Unsecured personal loans are a riskier proposition for the lenders. There is no guarantee that the borrower will pay the amount back in a timely manner. In the absence of any collateral, if the borrower fails to make the payment then the bank loses it money. In order to compensate for the greater amount of risk exposure banks charge a high personal loan interest rate. Some banks also charge a high application fee. Therefore one should compare the Annual percentage rate that represents the yearly cost of funds over the loan tenure to select the best option.
Credit rating- Unsecured Personal loan interest rates are also dependent on the credit score of an individual. You can expect to get reasonable personal loan interest rates only if you have an excellent CIBIL score. If you have a bad credit history, chances are that your application for an unsecured loan will get rejected at major banks. Some private lenders offer personal loans for low CIBIL score but they are often available at a very high rate. Such loans often tend to be quite expensive and are capable of burning a hole in your pocket. You should take such loans only in case of an emergency and that too when you are sure of future cash flows to repay the EMIs.
Precomputed interest- In many cases, the personal loan interest amount is calculated based on the agreed upon loan tenure and the original payment schedule. This essentially means that even if you pay back more amount than what was required, it won’t make any difference to the interest calculations. You would still have to pay a fixed precomputed interest amount.
Make sure you really need the funds before filing an application. If you are planning to use the loan amount to fulfil a want rather than a need, think again. Also analyse whether a secured loan makes more sense or an unsecured one. If you have an asset to offer as collateral it is always good to take a secured personal loan and save on interest costs. Borrow only as much as you can afford to pay back in a timely manner.
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