If you have ever been in a situation where you need large amounts of cash to tide over an emergency, then you know how worrisome it can get trying to figure out where exactly you are going to get the money from.

Thank god for personal loans! In almost every country in the world, you can borrow large sums of cash by taking out a personal loan. Since personal loans are unsecured and do not require you to provide any collateral or security, they are probably the best solution to financial emergencies. And as the name suggests, you can use a personal loan for absolutely anything. It doesn’t necessarily have to be a financial emergency.

Some of the most common reasons behind applying for a personal loan are:

  • A down payment for your wedding banquet

  • Travel purposes

  • Medical emergencies

  • To pay tuition fees

  • Tide over funeral expenses

Seems like a good solution to one’s financial needs, doesn’t it? In fact, there are numerous reasons for taking a personal loan. But before you do, it is important that you understand how they work. If not, you may just find yourself in a debt trap.

Here are a few things you need to know about how personal loans work:

  1. Familiarise Yourself With Commonly Used Terms

It is always a good idea to familiarise yourself with common terms that you are bound to come across while considering applying for a personal loan. An understanding of the following terms will also help you better understand what you are signing up for:

  • Principal: This is the amount that the bank agrees to lend you.

  • Interest: Always keep in mind that there are two kinds of interest – the advertised interest rate and the effective interest rate (EIR).

    • The advertised rate of interest is what you will find in all the marketing material provided by the bank.

    • The EIR is the true cost of the loan since it includes service fees and any other fee that is charged while your loan is being processed. Pay attention to the EIR before you apply for your loan.

  • Total Debt Servicing Ratio (TDSR): If you already have multiple loans, your application for a personal loan may be rejected on the grounds that it doesn’t meet the acceptable TDSR requirement. Monetary authorities across the globe, have established different limits for this ratio to ensure that people don’t borrow more than they can afford. According to this framework, your monthly debt payments, ideally, should not exceed 60% of your household monthly income.

Now that you understand these basic terms, let’s move on to the next step.

  1. Do Your Research

You know how you painstakingly compare features of two phones before you decide to buy one? That is exactly the level of research you need to put in while looking for a personal loan. Do your research thoroughly and read the terms and conditions. If a loan out there seems too good to be true, ask yourself why may this be the case? Are there any hidden fees and charges?

A great way to understand the fine print is to post your question on online forums that cater to finance. The responses you will receive will be genuine and unbiased since the chances of them being moderated by the bank are quite low.

  1. Do Not Make Multiple Applications

You may think that the best way to get a personal loan is to approach banks as a potential borrower and then apply for the loan and see if your application will be approved. However, what you may not know is that each time you apply for a loan, your credit report gets pulled up. And each time your credit report gets pulled up, it ends up affecting your credit score.

Say, for instance, that you approached 8 different banks in one month, enquired about their personal loan products and applied for 4 of them. This means that your credit report was pulled up each time you filled out and submitted your application. Let’s say that you apply for a personal loan from another bank post this. This bank will pull your credit report. They will see that in the last month, you have already applied 4 times for a personal loan. In their minds, this is a red flag. They may think that the reason you have made so many enquiries and submitted so many applications is because you are probably looking for a loan amount that you are not eligible for, or the bank may be suspicious of your reasons for taking a loan. All of this will eventually affect your credit score in a negative manner.

Of course, this is just an example and you aren’t really going to fill out 5 applications in a month. But it is important to keep in mind that every time you submit a loan application, your credit report gets pulled up.

This is why it is important to do your research before making an enquiry with the bank.

  1. Determine the Type of Personal Loan You Need

You’re probably reading this and thinking that all you need is a personal loan. But did you know that there are different types of personal loans? Most personal loans can be broadly divided into the following three types:

  • Personal instalment loan: This is the most common type of personal loan. The bank credits a predetermined amount of cash into your loan account, which you can then use as you wish. However, the interest that you are charged is on the entire loan amount and not just the amount that you have used. More often than not, the interest rate is fixed and you have to make instalment payments each month.

  • Credit line: Also known as a personal line of credit, this type of loan is known as a revolving loan. Here, the bank determines the amount they are willing to extend to you based on your monthly income. Most banks tend to extend personal lines of credit up to 4 times your monthly income. With a credit line, you only pay interest on the amount you use.

  • Balance transfer: A balance transfer loan allows you to transfer any of your current unsecured outstanding loans in one place, with a lower interest rate. This is especially useful if you want to consolidate your debt and make it more manageable.

It is important to note that revolving loans generally come with higher interest rates since there is a greater degree of flexibility that you can enjoy with the money. What’s more, revolving loans should be taken only if you are sure that you can make the payment for the amount withdrawn soon and should never be used as a source of money for long-term commitments.

  1. Keep Necessary Documents in Place

While each bank will require you to provide them with different documents, some documents are standard across banks. These include identity-related and income-related documents. More often than not, you will be asked to furnish the bank with copies of your monthly payslips and your tax returns. If you are a foreigner looking to apply for a loan, then you will be asked to provide a copy of your passport as well as a copy of your employment pass.

Do keep in mind, though, that these are just basic documents. Each bank may have a different set of requirements.

Following these 5 steps will help ensure three things. First, you will be able to determine what type of personal loan you are looking for. Second, you will be in a better position when it comes to understanding various terms and conditions as set out by the bank. And finally, you will be ready with everything you need for the bank to approve your loan with no hassles.

Author bio:

[author] [author_image timthumb=’on’][/author_image] [author_info]Nidhi Mahajan is writer and blogger.She loves to write Business and Finance news.For more information you can check her blog at[/author_info] [/author]

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