Loan hunting? Look beyond interest rates
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There is enough literature that cautions you against borrowing indiscriminately. If you have considered all the options available and the consequences on your finances and still decided to take a loan to fund a need, then the next step is to make sure that you take the precautions necessary to ensure that you make an informed decision. Here are some of the important aspects of taking a loan that you should be aware of.
Costs and fees matter
You need to get a complete picture of what the loan will cost you. This is not the interest alone, though it constitutes most of the cost of borrowing. There are fees and expenses involved in getting a loan processed and other conditions of the loan that makes the actual cost to the borrower vary from one lender to the next. The best way to understand the true cost of borrowing is to focus on the annual percentage rate (APR), which includes these factors apart from the interest rate.
If you have not been given the APR by a lender, you can calculate it from the expected monthly payments or EMIs (equated monthly instalments). First, calculate the total amount repayable by multiplying the EMI with the number of months of repayment. Deduct the principal loan from this amount to get what you are paying as total interest. Divide this by the number of years to get the yearly interest you will be paying. Divide the annual interest by the loan amount to get the APR. Where the additional costs have been built into the EMI, the APR will be higher than the published interest rate. Adjust the loan amount down where you have to pay the costs out of pocket. You can also use the PMT and Rate functions in the Microsoft Excel spreadsheet to calculate the EMI and the APR. The APR and total amount repayable help you compare between loans that may have different interest rates, down payments, costs and fees. Use them to help you identify the loan with the better financial terms, instead of looking at the interest rates alone.
Your borrowing costs go up with the fees and expenses that are tacked to a loan application. There are application and processing fees, administration fees, technical evaluation fees, legal fees for scrutinizing documents, prepayment fees, penalties and others that you have to deal with depending on the type of loan. Details of these fees may be cloaked in legalese and you ignore it either because you don’t understand how it affects you or you are so focused on getting the loan sanctioned that you overlook it. Ask for an itemized list of all the costs you will have to bear so that you are clear about the expenses and are able to evaluate across loan options.
If you are not confident that you will be able to pay the EMIs on time, then the penalty for missing EMIs is something you will want to watch out for. If you are likely to close the loan early, then the pre-payment fee may be of more interest to you.
Understand the terms
We tend to focus on the interest rates but there are other factors in the loan-evaluation process that need your attention too.
You may have to decide between fixed and variable interest rates. Choosing between the two may seem simple. If current interest rates are low, then tie into a fixed rate loan. If interest are expected to go down in the future, then a variable-rate loan would be the better choice. But predicting future interest rate movements is not easy, especially when it comes to long-term loans like a mortgage. A better option would be to look what suits your circumstances. Choose the fixed rate for long-term loans where the predictability of EMI is important to your planning and budgeting. In situations where you do not have much clarity or confidence about future income, it is useful to at least know that this expense will be fixed.
If you are sure you can pay off your loan quickly, before interest rates go up too much, it is better to go for a variable-rate loan. Know how often the interest rates will be reset and if there is a cap on how high the interest rates can go. If the loan is a secured loan, it can give you better terms, a larger loan amount and a longer tenure. But the risk is that of loss of the collateral provided as security if you are unable to meet repayment obligations. Know the conditions under which the lender can take possession of the collateral. Loan offers may come with tempting gimmicks like zero interest or EMI waivers or nil processing fees. The offers may seem attractive but beware of the strings attached. These may be in the form of: higher down payments, costs and fees under other heads, you may be locked into the contract for a period, it may mean that you don’t get a rebate on the product, or it may encourage you towards a product that may otherwise be unsuitable for you, say a floating rate or variable interest loan.
Very often, lenders tempt you to take a larger loan by showing lower EMIs or EMIs that fit into what you declare as your ability to pay each month. This is done by extending the term of the loan. However, this is not really in your interest since you are taking on a bigger loan than you actually need and you will be paying more as interest over the extended term of the loan. When you look at the total amount payable over the different tenures, it shows you how much more you are paying merely as interest, and may make you reconsider the decision.
Don’t focus only on one element of the loan that seems attractive. Instead, analyse the whole package before selecting the loan product that is most suitable for you.
We like familiarity, and the lenders know it too. So, don’t think that you are likely to get the best deal from a bank where you have an account or an institution with whom you have had a financial relationship. They may not give you the best deals. Shop around and find a suitable deal for yourself. Apart from the cost of borrowing, also look at the speed and convenience of applying and getting the loan sanctioned. A process that is transparent, and where your questions are answered to your satisfaction and thoroughly, gives you confidence in the lender. Servicing the loan once it has been disbursed is also an important element of the exercise. Check the reputation of lender on all these aspects before you take a final call on the loan.
Don’t take a lender’s low assessment of your credit worthiness at face value. At best, it may be a reflection of that particular lender’s narrow lending criteria. At worse, it may be a ploy to tie you to a high interest loan. Check with other lenders so that you get a fair idea of the best rates you can get.
Read the loan documents because all the information you need is in there. Don’t hesitate to ask questions if you don’t understand any clause or term. Be rigorous in evaluating your options so that you can be sure of getting the deal that meets your specific needs. Else, you may be stuck for a long time in a contract that may not be the best for your financial situation.