One of the most common parameters that people look at when they decide to apply for a loan is the applicable interest rate and the total interest that they will have to pay. Quite a few of us would prefer to opt for a loan wherein they pay the minimum interest over the principal.
While that is a crucial parameter to check, one of the more important factors to consider is the monthly EMI that you’d be paying. In an effort to keep the overall interest low, borrowers often end up paying higher EMIs or reducing balance loan EMIs wherein the initial installments are quite high. Monthly EMIs are important since they affect a host of other things including your eligibility for getting a future loan.
Hence, before you consider applying for a loan, you should check out a personal loan EMI calculator to see how much EMI you would be paying and opt for a tenure and interest rate accordingly. For example, for a loan of Rs 1,00,000 at 18% annual interest, and 24 months tenure will have an EMI of Rs 4992. For the same amount and interest rate, the EMI jumps to Rs 9168 when we choose a tenure of 12 months. This is an 83% increase, and has a more significant impact on your lifestyle.
This is not the only effect a higher EMI has on your finances. The EMI of your personal loan will create an impact on many other things, as detailed below.
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1. FOIR Is Important Consideration For Your Next Loan Or Credit Card Application
One of the most important criteria that lenders use to determine the loan eligibility of a borrower is FOIR, or ‘Fixed Obligations to Income Ratio’. The FOIR ratio takes into account all the set financial obligations that the loan applicant is required to meet on a regular monthly basis.
While FOIR does consider standard salary deductions (such as professional tax, Provident Fund, insurance payments, recurring deposits or other deductions made for investments), it does factor in the other outstanding loans that the applicant currently owes.
In the simplest terms, FOIR basically helps a lender determine whether a borrower will be able to afford the EMI easily. The criteria set by banks and lenders is that all borrowers should limit their fixed obligations (including the loan EMI they are currently applying for) to no more than 50% of their monthly income. That is, borrower’s entire monthly liabilities should be less than 50% of their monthly income.
Let’s say that you earn Rs. 50,000 per month and have taken a loan which has a monthly EMI of Rs 3,000. In addition to this, you have another loan with EMI of Rs 15,000. Since 50% of your income can be allotted to loan payments, the calculation of what loan amount you’ll likely be eligible for is as follows:
- 50% of Rs 50,000 = Rs. 25,000
- Loan #1 EMI= Rs 3,000
- Loan #2 EMI= Rs 15,000
Therefore, maximum EMI for a new loan would be:
- Rs. 25,000- (3000 + 15000)= Rs 7,000
This is how working backwards with the calculation of the potential borrower’s repayment capacity is ascertained, so as to in order to determine the loan amount the individual is eligible for. After calculating your eligible loan amount, use a personal loan EMI calculator to find out what your monthly installments will come up to.
FOIR can vary from bank to bank, but generally, most lenders consider an average of 40-50%. The lower your FOIR means a higher chance of getting your loan application approved by the lender. In case a borrower’s FOIR is quite high and goes above the ratio, banks will tend to reject the applicant despite having a perfectly good credit score and satisfying other criteria. This is because your disposable income post paying EMIs will be very low, resulting in a higher credit risk for the lender.
Thus, keeping your EMI as low as possible, and opting for longer tenures is in your favour when it comes to any dealings with the bank.
2. It Gives You Greater Flexibility With Monthly Expenses
As stated earlier, you can’t always guarantee that your monthly income will be able to meet every situation or requirement that can arise in the future. Furthermore, keeping expenses low isn’t a completely fool-proof method of safeguarding yourself against financial emergencies, simply because your current expenses are only bound to increase over time due to inflation.
Think about how external circumstances have an impact on your lifestyle. During extreme seasons such as summer and winter, your utility bills are bound spike up, causing a disruption to your monthly budget. In India, the festive season segues into the wedding season, which will undoubtedly results in a back-to-back hit on your bank account.
Aside from this, daily life inevitably causes wear and tear to basic necessities. Your home, vehicle, electronics, and other personal items are always going to require some form of repair or maintenance work, if not upgrading. These are all suitable reasons to take out a personal loan
3. It Can Improve Your Credit Score
Taking a personal loan isn’t just about receiving extra money to get by during a financial emergency, paying off the loan, and getting done with it. When you avail a loan, you’re also leaving a substantial impact on your credit score- for better or for worse.
Your credit score is one of the most critical components of a credit report that lenders use to assess an applicant’s creditworthiness. Just like an academic report card, your credit report is the history and assessment of your credit card and EMI payment history (including whether you’ve been only making late payments or defaulted, which is what determines your credit report. This score plays a deciding factor in whether a lender decides to approve or reject your loan.
By assessing your credit report on a regular basis, you’ll stay informed on how well you’re doing as a borrower. If you’ve ever made a late payment, you’ll be able to see how much of an effect it made on your score. So, if you check your credit report and get to know that your credit score is low, you can work towards improving it.
4. Better Terms for Your Next Loan
As a borrower, how you repay your loan is a demonstration of both personal and financial trustworthiness which is what credit scores like CIBIL scores indicate. This is why lenders tend to be wary of sanctioning loans to applicants with poor credit scores- they’ve got a proven bad rap! This is even applicable to potential borrowers who earn high salaries.
One of the key things to remember is that proving your ability to repay a loan will reap a multitude of benefits. The more timely payments you make, the higher your credit limit. And as your credit limit increases, you can borrow more money when you need it.
Borrowing larger amounts and paying them back responsibly causes your credit score to skyrocket, which subsequently makes you an attractive customer. Lenders will offer you better interest rates and repayment tenures because of your demonstrated fiscal responsibility.
5. Better Options
When you apply for a loan, you have the option of choosing the duration for which you would repay the loan. Longer tenures of 2-5 years will carry a lower interest rate, but more installments to pay, whereas shorter tenures have higher interest rates, resulting in higher EMIs to pay every month.
At any point of time, you have the option of foreclosing your loan early on. If you’ve opted for a shorter repayment tenure, it might put a strain on your finances temporarily. It’s recommended to opt for a longer repayment tenure for this reason; should you decide to foreclose at a later point, you’ll most likely have better financial resources at your disposal (via salary raises, bonuses, promotions etc) that can make it easier to pay off.