7 Risks of Availing a Personal Loan

May 24, 2024 / Reading Time: Approx. 10 mins

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7 Risks of Availing of a Personal Loan

In recent years with digital or online banking, there has been easy access to Personal Loans. The application process for these loans has been fairly easy compared to other loans, as there are no collaterals required and disbursement is quick.

Whether it is consolidating debt, funding a smartphone or any other gadget you wish to purchase, or covering unexpected expenses, personal loans offer easy access to money.

Financial institutions and fintech lenders have capitalised on this demand, offering competitive interest rates and personalised loan terms.

However, while the benefits of personal loans are undeniable, it is crucial to recognise that they are not without their risks. As a prudent, borrower you ought to decide to avail of a personal loan carefully because, at times, the ease and convenience of these loans can overshadow potential drawbacks.

From the possibility of accruing high interest rates to the dangers of overborrowing and impacting one's credit score, personal loans can present several challenges if not managed prudently.

In this article I elucidate the 7 key risks associated with availing of a personal loan, providing essential insights to help you make informed financial decisions and avoid common traps.

[Click Here to Download Our Free Guide "Your Definitive Guide to Avail of a Personal Loan in India"]

1. Higher Interest Rate:

One of the primary risks associated with personal loans is the higher interest rates compared to other types of loans that are usually backed by collaterals.

Personal loans, on the other hand, are unsecured loans - not requiring you to provide any form of collateral. While this can be an attractive feature for borrowers, it also translates into higher risk for lenders. Therefore, lenders often charge higher interest rates on personal loans to mitigate this risk than secured loans.

Now if your credit score is excellent (750 and above), the lender may offer you the personal loan are a lower or relatively competitive interest rate. However, individuals with not-so-appealing credit scores may face significantly higher rates, making the cost of borrowing much more expensive. Even a seemingly small difference in interest rates can substantially increase the total repayment amount over the life of the loan.

For instance, a Rs 2 lakh personal loan at an 11% interest rate, will cost significantly less over time compared to the same loan at an 18% interest rate. Hence, it is essential to carefully evaluate the interest rate offered and consider its long-term impact on your financial well-being before availing of a personal loan.

[Use PersonalFN's Personal Loan EMI Calculator to Calculate Your EMI and Know Your Total Interest Outgo.]

[Also Read: How to Use a Personal Loan Calculator Effectively A User-Friendly Guide]

2. Debt Accumulation:

Another significant risk of availing of a personal loan is debt accumulation. While a personal loan can provide immediate financial relief, it can also lead to a cycle of borrowing if not managed sensibly.

This is because a loan EMIs you add to your existing financial obligations. Without a clear and disciplined repayment plan, it could add to your debt burden. If an unexpected expense arises during your personal loan tenure, it could strain your budget. And when you are unable to make the loan repayment, apart from additional financial penalties, it hurts your credit score. It is thus crucial to assess your overall financial situation and ensure that taking on a personal loan will not lead to unmanageable debt accumulation.

Many borrowers use personal loans to consolidate other debts, such as credit card balances. While this can simplify payments and sometimes reduce interest rates, it does not eliminate the debt. In some cases, individuals might feel a false sense of financial freedom after consolidating debts, leading them to continue spending and accumulating new debt. This behaviour can negate the benefits of the consolidation and result in an even higher overall debt burden.

3. High Processing Fees and Prepayment Penalties:

Personal loans are offered at A high processing fee and there are prepayment penalties. The processing fees could typically range from 1% to 5% of the loan amount.

For instance, a Rs 2 lakh personal loan with a 3% processing fee will cost you an additional Rs 6,000, which is often deducted from the loan disbursement. This means you receive less money than you initially borrowed but are still responsible for repaying the full loan amount. In other words, there is a cost of borrowing.

Moreover, prepayment penalties can also be a substantial financial drawback. Some lenders impose penalties if you choose to pay off your loan early, which may seem unreasonable -- akin to a cost -- even to prepay the personal loan. This is done by lenders to recover the loss as the loan is being paid by you sooner than agreed. The prepayment charges you pay are usually a percentage of the remaining or outstanding loan balance.

Hence, before committing to a personal loan, it is essential to carefully read the loan agreement and understand all associated fees and penalties. These costs can significantly impact the loan's overall affordability and financial benefits.

4. Privacy Concerns:

Privacy concerns are another critical risk when taking out a personal loan. The application process for a personal loan typically requires you to share extensive personal and financial information, including your income details, employment history, family details, and bank account information. This data is sensitive and, if not handled securely by the lender, can be vulnerable to breaches and identity theft. There have been many such cases in India, especially related to fake instant loan apps.

Moreover, some lenders might share your information with third-party marketers or affiliates, leading to unsolicited offers and potential misuse of your data. It is essential to thoroughly research and choose a reputed lender with robust privacy policies and data protection measures in place.

Reading reviews, checking for complaints, and understanding the lender's privacy policy can help safeguard your personal information. Ensuring your data is handled responsibly is crucial to preventing privacy breaches, which can have a long-lasting impact on your financial security and personal identity.

5. Damage to Your Credit Score:

Availing of a personal loan can also pose a risk to your credit score. When you apply for a personal loan, the lender typically performs a hard enquiry on your credit report, which can temporarily lower your credit score. While the impact of this may not be significant, making multiple enquiries for loans, in the short term may weigh down on your credit score.

Furthermore, your credit score can suffer if you struggle to make timely payments on your personal loan. Late or missed payments are reported to credit bureaus and can remain on your credit report for several years, thus reflecting poorly on your creditworthiness. This negative mark can make it more challenging to secure favourable terms on future loans or credit cards.

Additionally, high loan balances compared to your income, increases your debt-to-income ratio -- which lenders use to assess your ability to manage debt. A high debt-to-income ratio signals financial stress, impacts your credit score and limits your borrowing options.

[Also Read: 8 Sure-fire Ways to Improve Your Personal Loan Eligibility]

6. Potential Default:

A potential default is a significant risk associated when availing of a personal loan. A 'default' occurs when you fail to make the required payments on your loan, leading to severe financial consequences.

If you default, the lender may impose hefty late payment fees and additional interest charges, which increase your overall debt burden.

Moreover, defaults are reported to credit bureaus, severely damaging your credit score and making it difficult to obtain credit in the future.

The repercussions of defaulting extend beyond financial penalties. Lenders may take legal action to recover the amount owed by you. This could add to your stress and anxiety associated with financial instability and may impact your overall well-being.

To avoid default, it is crucial to assess your ability to meet the loan obligation carefully before borrowing. Ensure you have a stable income and a budget that accommodates the loan EMIs and consider setting up an emergency fund to cover unexpected expenses.

7. Added Insurance Charges:

As a personal loan is unsecured, some lenders require or strongly encourage you, the borrower to purchase loan insurance to protect against default in case of unforeseen circumstances like job loss or illness.

While loan insurance provides a safety net, mind you it also increases the overall cost of the loan. Premiums are loaded into your monthly loan EMIs, making the loan more expensive over time. It is important to assess whether the benefits of such insurance outweigh the additional cost and to consider if you truly need this extra protection.

To conclude:

While personal loans offer convenience and flexibility, they come with inherent risks that require careful consideration. Factors such as higher interest rates, high processing fees, prepayment penalties, privacy concerns, potential debt accumulation, loan default, possible damage to your credit score, and additional insurance charges can all adversely impact your financial health.

To make the most informed decision, it is essential to thoroughly understand these risks, evaluate your financial situation, and choose reputable lenders.

More important, borrow an amount with due consideration to your means. Doing so shall help leverage the benefits of personal loans while minimising potential consequences and ensure a more secure and manageable financial future.

Be thoughtful when managing your personal finances.

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ROUNAQ NEROY heads the content activity at PersonalFN and is the Chief Editor of PersonalFN’s newsletter, The Daily Wealth Letter.
As the co-editor of premium services, viz. Investment Ideas Note, the Multi-Asset Corner Report, and the Retire Rich Report; Rounaq brings forth potentially the best investment ideas and opportunities to help investors plan for a happy and blissful financial future.
He has also authored and been the voice of PersonalFN’s e-learning course -- which aims at helping investors become their own financial planners. Besides, he actively contributes to a variety of issues of Money Simplified, PersonalFN’s e-guides in the endeavour and passion to educate investors.
He is a post-graduate in commerce (M. Com), with an MBA in Finance, and a gold medallist in Certificate Programme in Capital Market (from BSE Training Institute in association with JBIMS). Rounaq holds over 18+ years of experience in the financial services industry.

Disclaimer: This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes. Use of this information is at the user's own risk. The user must make his own investment decisions based on his specific investment objective and financial position and use such independent advisors as he believes necessary.

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