A line of credit, personal loan, and credit card are all unsecured loan instruments, which means that no collateral or collateral needs to be posted to use credit through any of the three.
The way they work is simple: Instead of relying on a borrower’s assets as collateral, lenders approve unsecured loans based on the creditworthiness of the borrower. If a borrower defaults or does not repay an unsecured loan, the lender can settle the case in court or can assign a collection agency to collect the loaned money.
Let’s take a look at how a line of credit, personal loan, and credit card work and how you can get one.
How does a line of credit work?
A line of credit is a form of unsecured loan, in which you can access small to medium capital ranging from INR 5,000 to INR 2,000,000 or more in some cases.
It is a unique type of credit product that allows borrowers to avail of a loan and use the required amount as needed, and only pay interest on the amount of principal used instead of all of it. of the amount borrowed.
When the borrower repays the monthly payment or the EMI on the amount used, the entire credit line is again available to him.
Here’s how a line of credit works:
- After the application process, you get INR 80,000 approved on your line of credit. Of the total amount of INR 80,000, you choose to use only INR 50,000.
- In this case, you will have to pay interest on INR 50,000, not the full INR 80,000.
- Money is a cash transfer to your bank account and you can use it for any need you might have.
- Once the first amount of INR 50,000 is used, the remaining credit line available is reduced from INR 80,000 to INR 30,000.
- The repayment term of the loan amount varies from two months to three years depending on the repayment capacity of the individual.
- Suppose you choose a six month installment repayment term, you can repay the INR 50,000 in six months with interest. And when you start repaying, your credit limit is reset.
- After six months, the full limit is available again. Remember, you can borrow any amount for any term as long as it stays within your available limit.
- The interest rate varies depending on the amount of money borrowed and the length of tenure, but is generally similar to that of personal loans.
How does a personal loan work?
Majority of personal loans in India are unsecured which means that they do not require collateral which borrowers must submit when taking out a loan. Unsecured personal loans come in many forms but have one feature in common – they are disbursed as lump sum loans and you have to start paying interest on the full amount borrowed from the day you take out the loan.
Here are some examples of unsecured personal loans:
- A wedding loan is designed to fund all or some aspects of a marriage.
- A vacation loan is intended to finance a trip.
- A home renovation loan can be used to improve your home or parts of it.
- A ready for sustainable consumption can be chosen to buy goods or electronic devices such as laptops, smartphones, washing machines, among others.
Here’s how a personal loan works:
- The duration of these loans is three years on average and can go up to five years in some cases. Most of the repayment is collected monthly and the finance company, banks or others, generally does not prefer that you prepay your loan.
- A prepayment penalty is charged if you close your loan early. The reason is simple: Once the finance company understands that you are creditworthy, they prefer to charge as much interest as possible to recoup their costs and make a profit.
- Nonetheless, these types of loans are useful if you have a clear and urgent need for a large sum of money and don’t mind paying the interest over the set term.
- The interest rate for a personal loan typically ranges from 12% to 18% if you have a good credit rating. This interest rate on an unsecured loan can vary from one lender to another.
- Some lenders might charge interest rates as low as 7% and as high as 36%. But there are others that charge very high rates ranging from 150% to even 1000% and more with the processing fee. These lenders operate in the space of payday loans, that is, loans given for ultra-short terms, usually between 7 and 30 days.
- For unsecured loans, there are no collateral and hence, there is no guaranteed income for the lender in the event that the borrower defaults. So, here the risk becomes high for the lender. To adjust for this risk, lenders tend to charge a higher rate of interest on unsecured loans. However, a default will affect the credit rating of the borrower.
- However, if you want to make this decision wisely, make sure you maintain a good credit rating, ideally between 700 and 900. This will help you benefit from more loan options at much lower interest rates over time. desired.
- Borrowers are recommended to be cautious when taking out a personal loan and are encouraged to know the exact details of their loan before contacting lenders.
How does a credit card work?
A credit card is a completely different product than a line of credit and a personal loan.
In layman’s language, a credit card is simply a plastic card issued by a bank that you can use to make purchases and pay interest on credit used up to a predefined limit. You are billed monthly for used credit, and failure to pay the card amount or invoice on time results in interest on the credit used.
Here’s how a credit card works:
- If you pay your bill on time, you pay zero interest and that makes it a convenient product to use. Some credit cards allow you to withdraw money from an automated teller machine (ATM), just like a debit card.
- If you do not pay your bill on time or only pay the minimum amount due or withdraw money through your credit card, you will have to pay interest rates ranging from 38% to 42%, including late fees and charges.
- This interest rate on a credit card is almost twice as high as a personal loan.
- A careful reader might ask: if Mr. R buys for 1000 INR today and pays his bills 30 days later, who pays the interest for those 30 days?
- The answer is simple: it is the merchant with whom Mr. R shopped who pays this interest.
- Companies with credit cards like Visa and Mastercard make sure they collect 1-2% of the fee from where you shop and which is used to fund the 30 days of interest-free shopping for the consumer. This is the reason why even now, if Mr. R makes very large credit card transactions, some merchants will charge him minimal fees for it. Otherwise, they will have to pay it out of their own pockets.
- The store or merchant pays the additional 2% fee as it has been proven time and time again that Mr. R will buy a lot more with a credit card than with cash transactions in the near future.
Steps to opt for a loan product
In order for a lender to offer you the most suitable product, you need to follow a few simple steps:
- You have to share your personal data with the proposed lender.
- The lender will pull your credit history through data provided by the credit bureaus to determine if you paid off your previous loans on time, tax returns to verify your repayment capacity, and a few other relevant documents to confirm your identity, such as the PAN card and Aadhaar card among others.
- After careful consideration, they will decide if they will issue you a loan product and set an interest rate based on the data they have.
- You will be able to choose between the best quotes available to you through your lender (s).
The main idea behind one of the three unsecured loan products is to make borrowing less burdensome by making funds accessible to people with urgent financial needs. So if you choose one of the three loan products, ask lots of questions before signing up and always pay your dues on time.
In a nutshell, personal loans are generally better for larger one-time expenses that take longer to pay off. Credit cards are best for small expenses that can be paid off relatively quickly. This is because credit cards tend to have higher interest rates than personal loans, so keeping a balance on a card for a long time can be costly. However, a line of credit may be the best option for many clients when they may have a frequent need for capital and seek the flexibility of having funds available to them as and when they need it.