A cost-benefit analysis

Before opting for a personal loan, you must be aware of the method of calculation of the interest rate. This is important, to compare other options (interest rates) available to you. Personal loans usually come with either a flat rate, a reducing balance or advance EMI (normally used for consumer durable loans).

Take the case of the flat rate, where what is charged is basically simple interest. So, if you take a personal loan of Rs 200,000 at a flat rate of 15 per cent, your interest is going to be Rs. 30,000 a year for the loan tenure. In the case of reducing balance, the EMI and the interest computation are equated in EMIs over the tenure and then you are charged. The interest is charged on the balance outstanding. Effectively, this means that between a 10 per cent flat and 10 per cent reducing EMI method for the same tenure, the reducing balance is a cheaper option.

In Advance EMI, lenders normally take two-three EMIs in advance, effectively reducing your principal amount. Interest is charged on the entire amount, instead of the reduced principal interest. So, for a loan of Rs 200,000 with three advance EMIs (Rs 30,000), your loan may actually be for 170,000 but you may be charged interest on the entire Rs 200,000.

Once aware of the method of calculation of interest, it will help you in weighing the various options available at the time of prepayment and you are able to make a better judgement.

In prepayment, an important factor is the penalty you will have to pay while making early payoff. If you have gone for a 1-year, 2-year, 3-year or 5-year personal loan and you decide to prepay the entire amount, banks would charge you anywhere in the range of 4- 5 per cent penalty.

Also, when the bank offers you the option of prepayment, it does not give the flexibility of part-payment .If you decide to repay the loan earlier than the pre-determined period, you have to pay the whole outstanding principal. If you have a minimal surplus available to pay a part of your loan that would reduce your interest burden, the bank does not allow it.

A personal loan is an effective tool to meet any financial emergencies or contingency requirements like medical, marriage, family function, education, vacations, travel, home purchase, improvements, etc. No security is needed, but the qualifying criterion is quite stringent, as the risk involved is greater. But banks are more than happy to entertain qualified individuals/professionals, which require minimal paperwork. Personal loans are cheaper than credit cards, but more expensive than home loans.

The writer is vice president, www.apnapaisa.com