Why Opting for a Personal Loan Could Endanger Your Financial Wellbeing

The ease of access and the lure of immediate funds can lead to impulsive borrowing, which in turn results in unmanageable debt. With high interest rates and rigid repayment terms, a personal loan can quickly snowball into a financial burden, consuming a substantial portion of your monthly income. This can leave you struggling to meet essential expenses or save for future goals.

As a financial advisor, I have seen clients face the detrimental consequences of over-reliance on personal loans-often trapped in a cycle of debt. While personal loans can be useful in emergencies, it is essential to understand their potential pitfalls. This article elucidates why taking out a personal loan without careful consideration could undermine your financial wellbeing, and how you can make more informed decisions when borrowing money.

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The Rising Trend of Personal Loans in India

According to CRIF High Mark's recent report, India's consumer loans have surged by 15.2% in the Financial Year 2023-24, reaching a staggering Rs 90.30 lakh crore. Among these, personal loans have seen the highest growth, increasing by 25.6%, followed by a 20% rise in auto loans. In contrast, home loans typically availed to build an appreciating asset, have grown more modestly at 7.9%.

This data highlights a concerning trend: to meet growing aspirations, many consumers are opting for personal and auto loans at an alarming rate. Personal loans, in particular, are often sought after during the festive season, when people feel the urge to spend on celebrations, gifts, or big-ticket purchases. While these loans can provide instant gratification, the long-term financial impact can be detrimental if not managed wisely.

Unlike home loans, which contribute to building a valuable asset, personal loans and auto loans typically fund depreciating assets or short-term needs, offering no real financial growth. As more people rely on these forms of debt to meet their aspirations, they risk falling into a cycle of financial strain, especially with the high interest rates attached to personal loans. This makes it crucial to weigh the long-term consequences before opting for such credit options.

Caution from the RBI

Reserve Bank of India (RBI) Governor Mr Shaktikanta Das has cautioned lenders against the aggressive growth of personal loans, emphasising the need for prudence. He raised concerns over the rapid expansion in this segment, urging banks to ensure that lending practices remain sustainable and do not compromise financial stability. Das highlighted the potential risks of over-lending in the personal loan space, particularly as it could lead to rising defaults and financial strain.

Mr Shaktikanta Das's warning is timely, as the increasing reliance on personal loans is not only risky for individual borrowers but also for the banking system as a whole. When people borrow more than they can afford to repay, defaults rise, creating a ripple effect that can destabilise the economy. This is why both borrowers and lenders must tread carefully when dealing with personal loans.

The Hidden Costs of Personal Loans

One of the primary reasons personal loans can be dangerous to your financial health is the high interest rates they often carry. Unlike secured loans like home loans, which are backed by an asset and thus come with lower interest rates, personal loans are unsecured. The absence of collateral means lenders charge higher rates to compensate for the increased risk.

In India, personal loan interest rates can range from 10% to 24%, depending on factors such as your credit score, income, and the lender's policies. While the monthly payments might seem manageable at first, the overall cost of borrowing can add up significantly over time. This can strain your cash flow and limit your ability to save for other financial goals, such as retirement or your child's education.

Furthermore, many people underestimate the total repayment amount when taking out a personal loan. For instance, a loan of Rs 5 lakh with an interest rate of 15% over five years could end up costing nearly Rs 7.12 lakh in total. This significant difference between the principal and the total repayment is often overlooked, leading borrowers into a debt trap.

Impact on Your Credit Score

Another key factor to consider is the impact of personal loans on your credit score. Each time you apply for a personal loan, the lender performs a hard inquiry on your credit report, which can cause a temporary dip in your score. More importantly, if you struggle to make timely payments or default on the loan, your credit score will take a substantial hit. A poor credit score not only affects your chances of getting approved for future loans but also results in higher interest rates on any credit you manage to secure.

Moreover, many borrowers opt for additional loans to cover their existing debt, which can lead to a vicious cycle of borrowing and repayment. This ongoing cycle can be difficult to break and will continue to erode your credit score, making it even harder to regain financial stability.

Debt Trap and Mental Health

The mental burden of being trapped in debt cannot be overstated. Financial stress is one of the leading causes of anxiety and depression, and personal loans can worsen this issue. As monthly payments become harder to manage, the pressure to find extra money or cut back on essential expenses can create a constant state of worry.

In extreme cases, borrowers may resort to other high-interest debt, such as credit cards, to make ends meet. This only worsens the financial situation, leading to a debt spiral that can be incredibly hard to escape. The combination of mounting debt and poor financial health can significantly affect your mental wellbeing and overall quality of life.

Alternatives to Personal Loans

Before taking out a personal loan, it is crucial to explore other financial options that may be less risky. For example:

Emergency Fund: Building an emergency fund is one of the best ways to prepare for unexpected expenses. A well-stocked emergency fund can help you avoid the need for a personal loan altogether.

Credit Cards with Low Interest: If you need to borrow for a short period, a credit card with a lower interest rate or a 0% introductory APR offer can be a better option, provided you can repay the balance within the promotional period.

Borrow from Family or Friends: While this may not always be an option, borrowing from a trusted friend or family member could help you avoid high-interest debt. Just be sure to set clear terms and repay the loan promptly to avoid damaging personal relationships.

Debt Consolidation Loans: If you are looking to consolidate high-interest debt, consider a debt consolidation loan with a lower interest rate than your existing loans. This can help you manage repayments more efficiently without taking on additional high-interest personal loans.

To conclude:

While personal loans may seem like an easy solution to meet immediate financial needs, they come with significant risks that could jeopardise your financial wellbeing. The rapid rise in personal loan borrowing, particularly in India, reflects a trend driven by growing consumer aspirations. However, high interest rates, hidden costs, and the potential for falling into a debt trap make personal loans a dangerous financial tool if not used wisely.

Before opting for a personal loan, take time to assess your financial situation and explore alternative options. Building a robust financial plan, creating an emergency fund, and carefully evaluating your borrowing needs can help you avoid the pitfalls of personal loans and maintain long-term financial health. Remember, while borrowing may offer temporary relief, it should never come at the cost of your future financial stability.

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Hiral Bhuta is a Investment Consultant & Principal Officer. She is a seasoned professional in the financial services industry, currently serving as an Investment Advisor and Financial Planner at PersonalFN. With her expertise, she plays a pivotal role as the Principal Officer appointed under SEBI's amended IA Regulation. Hiral holds distinguished certifications such as Certified Financial Planner (CFP) and NISM XA & XB, complemented by a post-graduate degree in commerce (M. Com). Her primary areas of focus encompass financial planning, investment advisory, and wealth management, where she leverages her knowledge and skills to provide tailored solutions to clients. With a cumulative experience spanning five years, Hiral brings a wealth of expertise and insight to her role at PersonalFN, ensuring clients receive expert guidance and support in navigating their financial goals.
 

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