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9 Rules to Follow Before You Take a Loan

9 Rules to Follow Before You Take a Loan

9 tips for taking a loan

With the rising cost of living, it is evident that you may feel a pinch of financial crunch at some point in time, and when emergency savings are not enough to bail out then taking a loan seems to be the next best option. But before you take out a loan, you have to consider a few things – how much to borrow, the purpose of the loan, type of loan (secured or unsecured), financial institution to apply with, etc. Apart from the said factors, there are a few more to consider when choosing a loan.

In the following post, we will discuss a practical approach to borrowing funds so that you do not fall into a debt trap or encounter any financial stress.

  1. Borrow Only an Amount You Can Repay

Availing loans today is like a piece of cake. You can apply for funds online, no need to personally visit a bank branch to make a loan application. You will also find pre-approved loan offers. But, just because a loan is easily available, you must not go for it until necessary. And even if you still choose to borrow, request only for a loan amount you need.

  • So, have a clear idea about the loan amount that will be sufficient to meet your financial requirements.
  • As a thumb rule, your monthly outgo towards loans must not exceed 40%-50% of your monthly income. Ensure that the loan-to-income ratio is within acceptable limits.
  • If the EMIs eat away at most of your income, then you will have limited disposable income, insufficient to take care of other financials such as investments, retirement plans, savings for kid’s education, etc.
  1. Debt Consolidation with a Low-Cost Loan

If you have too many ongoing loans, then you can consider debt consolidation under a single low-cost loan. Especially high-cost ones such as personal loans, credit card loans, car loans, etc can be substituted with cheaper loans, such as a loan against gold, property, LIC, or bank deposits (as these are secured loans and incur lower rates than unsecured ones).

However, a loan for purchasing a home or pursuing an education offers tax benefits. But tax benefits must not be the alone reason to keep a loan running, after all, if you can avoid an expense by ending a loan early then why not go for it?

  1. Do Not Borrow for Investments and Overspending

Never borrow money for an investment purpose. Investments such as bonds and fixed deposits will not match the interest amount you pay on a loan. If you plan to take out a loan to invest in financial instruments that give higher returns such as equities, know that the latter too is volatile. So if the market declines, you will run into losses and find it difficult to even afford the EMIs.

Avoid taking loans for discretionary spendings, such as travel, purchasing luxury items, throwing a party, etc. If you have to request funds, do so to build an eminent asset such as a house, which will give you healthy returns as property rates increase.

  1. Keep a Lookout for Lower Interest Rates

Policies by banks and RBI influence the interest rate on loans. If you borrow at a floating rate, then the rates can change as per the policy adopted by the bank. You could be paying more as years go by than what you pay today. So, the best way to keep interest payout low is to shop for better rates. For instance, if you have taken a home loan at 10% but another bank is offering the loan is 9%, then you may want to transfer the home loan to this new bank and reduce the interest cost.

  • The Reserve Bank of India has done away with prepayment penalties on housing loans, but not for unsecured loans, so be wary of the penal charges when opting for a balance transfer.
  • The charges must not surpass the benefits of reduced costs offered by the new bank, or switching the loan to another institution will be pointless.
  • Remember, the earlier you switch a loan to better rates, the greater will be the benefits.
  1. Pay the EMIs in a Timely Manner

Paying EMIs on time ensures a good credit history and score, which in turn helps get the best interest rate and the loan offer. A CIBIL score of 700+ indicates that you are a credible borrower who shall not default at payments. On the other hand, if you miss or delay payments, then your credit score can take a hit. A low credit score will reduce the chances of availing of a loan in future.

  • Defaulting on payments incurs additional penalty charges. Thus, the financial burden of debt increases, negatively affecting your life and financial goals.
  • Remember to prioritize paying dues even if it means following a strict budget or doing away with a few luxuries.
  • Non-payment penalties along with hefty interest on unpaid amounts can drain out your finances otherwise in a short time.
  1. Choose Insurance for Big-Ticket Loans

If you intend to purchase a house, then take an insurance cover like a term plan of the same amount of the loan or the property’s value so that in case of an unfortunate event, your family can still pay off the debt. Otherwise, the financial institution can auction off the house to recover the outstanding dues.

  • Some banks offer term plans on a reducing cover, which is equal to the outstanding loan amount. To find out the best insurance policy that you can take when availing of a big-ticket loan.
  • There could be an instance where the bank offers an insurance plan with the loan but do not go ahead with the same until you check out the marketplace.
  • Only if the bank-offered insurance plan is better than those in the marketplace, should you go ahead with it, or you can make a better plan from any other insurance provider as well.
  1. Go for the Shortest Possible Tenure

Secured loans such as home loans and property loans come with a longer tenure than unsecured loans, such as personal loans and business loans. A housing loan’s tenure can be as long as 30 years, while the same for a loan against property is up to 20-25 years. Personal loan tenure, on the other hand, does not exceed 5 years.

  • EMIs on a longer tenure are lesser than otherwise. However, a longer tenure will also increase the interest payout.
  • Ideally, if you can afford to repay a loan early, then choose the shortest tenure possible.
  • This way you can significantly save on interest paid, especially if the loan is taken on a floating interest rate. After all, the longer the tenure, the higher the compound interest.

Sometimes you may have to choose a longer tenure, in case your income is low or insufficient to repay the loan faster. In this scenario, try to contribute more towards the EMI amount every year. For instance, if you get a salary hike or yearly bonus, then use these to repay the loan sooner and reduce the EMI burden.

  1. Do Not Dip Into Retirement Funds

Many of us ignore planning for retirement and direct funds towards securing assets and giving a bright future to our own kids. However, building a sufficient retirement corpus is equally crucial. So, rather than taking an education loan yourself, you can ask your child to take one for studies, which can be paid back once his/her income starts flowing in.

This way, you can keep up with retirement goals as well as not hamper your child’s education. Similarly, do not exhaust your retirement savings on weddings, events, debts, etc. Keep these funds untouched and find some other solution to take care of the monetary needs.

  1. Read and Understand the Loan Agreement

Sign the loan agreement only after reading it thoroughly, paragraph after paragraph. Understand all the terms and conditions to avoid unpleasant surprises. Some lenders slip in clauses that are detrimental to the borrower’s interest, like a hidden fee or cost that is not disclosed upfront.

  • For instance, the loan documents can mention an upfront interest charge on the insurance premium which was not disclosed by the bank while communicating details of the loan deal.
  • And if you do not go through the fine print properly, then you will have no idea why the loan amount received is less than what was promised.
  • If you need help understanding the legalese, then hire a Chartered Accountant or a financial adviser to take a look at the agreement before signing the same.

To Conclude

Borrowing money for personal or any need is a significant financial step. Loans are a responsibility that cannot be shirked. So before you take out a loan, know how much money you need and the purpose of the same. Also, consider the above-mentioned factors so that you can take an informed decision before borrowing funds.

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