How Credit Score Impacts The Interest Rate of Personal Loan
Money borrowed from a lender with a promise to pay back within a given timeframe is essentially referred to as a loan. Along with the borrowed amount, the borrower has to pay interest at a rate decided by the lender. Loans are classified into two types: secured loans and unsecured loans.
Secured Loans Loans where the borrower has to pledge some collateral as security are called secured loans. The pledged asset acts as security against the loan in case of a default. If there is a payment default, the lender can sell off the pledged asset to recover the loan. Housing loans, car loans, loans against property are some examples of secured loan. Till the time the loan is fully paid back, the assets pledged as security remain mortgaged with the lenders.
As the name suggests, loans which are not secured by any collateral are called the unsecured loan. A loan is sanctioned based on the creditworthiness of the borrower. Based on the past track record and expected future earnings of the borrower, an unsecured loan is sanctioned. As the risk involved for the lender is higher, unsecured loans come at a relatively higher rate of interest as compared to secured loans. Some examples of unsecured loans are personal loans, student loans, and credit cards debts. In this article, we will focus our attention on personal loans only.
Personal loan by its definition means it can be used for any personal need, be it to finance a vacation, house renovation, to meet unexpected medical emergencies, etc. There is no predefined objective or end use for the loan as in the case of car or home loans. The lenders, banks or NBFCs, do not monitor how and where the money is utilized. Generally speaking, personal loans are unsecured. There is no collateral attached to it. It is sanctioned based on the creditworthiness of the borrower – past repayment history, employment status, current and expected future income, existing liabilities, etc. There are, however, some forms of secured personal loans as well.
Secured Personal Loan
Secured personal loans, as the name suggest, are obtained by pledging some asset as security. These loans carry a significantly lower rate of interest as compared to unsecured personal loans. Unlike some other secured loans which have straight forward objectives, personal loans do not have any predefined terms for its end use. Some types of secured personal loans are:
- Loan against property: here the borrower pledges his/ her property, land or house, as security against the intended loan amount. The maximum amount that can be borrowed depends on the current market value of the property.
- Loan against shares: here the equity shares of listed companies held by the borrower are taken as security for the loan. The current market price of the shares determines the maximum amount that can be sanctioned.
- Loan against mutual funds: here the mutual fund units held are taken as security and the net asset value of the units are taken into account while deciding on the loan amount.
- Gold loans: the gold holding of the borrower, whether in physical or virtual form, is pledged as security.
- Loan against life insurance policies: except for term policies and unit-linked policies, any endowment policy can be used to secure a loan. The present surrender value of the policy determines the maximum loan that can be availed. In the case of gold loans and loans against shares, market volatility is also taken into consideration while deciding upon the loan amount.
As stated earlier, availing the unsecured personal loan is contingent upon the creditworthiness of the borrower. A person with a good credit score, as defined by credit rating agencies like CIBIL, can get a personal loan quite easily and that too at competitive interest rates, provided he/she meets other laid down criteria. For persons with low or poor credit score, getting a personal loan is a difficult task. Banks generally shy away from giving loans to such people. However, there are some NBFCs and other private lenders, who give personal loans for bad credit as well. As the risk involved with such people is considerably higher, the rate of interest charged by lenders is also high. Besides, lenders might also ask for guarantors to these loans. The guarantors are liable to pay the outstanding loan amount in case of default by the borrower. Guarantors are, therefore, are not easy to get. A personal loan for persons with bad credit is helpful if it eases his/her current debt obligations, like high-interest credit card debts. Nevertheless, extreme caution should be exercised while going for such loans.