What factors affect the interest rate on personal loans?
It is important to note that personal loans are the most expensive loans in the formal consumer banking system. Interest rates on personal loans in India generally range from 14-25% though, of course, it could be higher or lower depending on each individual bank or lender’s internal policies and lending criteria.
The reason personal loans incur the highest interest rates are because they are ‘unsecured’ loans. An unsecured loan is one where you do not need to provide any collateral to the bank/lender. In the case of a secured loan – like a home or auto loan – the property and vehicle to be purchased are held as collateral by the lender until the entire loan amount is repaid. In case of default, they can use the collateral to recover their dues.
However, in a personal loan, the lenders are taking the risk of lending to you without any security and have no safeguards against default. This is why they tend to cover their risk by charging a higher interest rate when compared to secured loans.
Factors influencing the interest rate on personal loans:
1.Loan amount compared to your annual income: If your loan amount is a small percentage of your annual income, then your interest rate will tend to be lower as lenders think you will have enough income to fulfill your loan obligation. They will perceive you as being at relatively low risk of defaulting and may be willing to offer a lower rate of interest.
2.Conversely, if your loan amount is a high percentage of your annual income, lenders might not be confident about your ability to have enough income to make all your repayments and might insist on a higher interest rate on the loan.
3.Credit report and credit score: Since this is an unsecured loan, lenders want to track your past credit behaviour in order to evaluate your ability and willingness to pay. In general, the higher your credit score, the better the interest rate you will get. If you have a good credit score, lenders are confident that you have a good track record of fulfilling your debt obligations, and you might be able to negotiate a lower interest rate with them.
Given the high interest rates on personal loans are, it is important to check the rate on the loan you are applying for. Make sure that you have a plan to make all your repayments on time so that you avoid harming your credit health.