Personal loans: Is it wise to borrow money to repay existing debts? Here’s what you need to know

Do you have multiple loans to repay and worry that settling them all will take a long time? While there are several strategies for managing debt, one option is to use a new personal loan to pay off existing ones.

Although this approach may seem risky, and some might warn against it to avoid falling into a debt trap, it can be a practical solution under certain conditions. It might not be as bad an idea as some may make it appear.

For example, if you have ₹2 lakh in credit card bills with a 24 percent annual interest rate, ₹3 lakh in a personal loan at a 12 percent annual interest rate, and ₹1.5 lakh borrowed from a friend, sticking with the status quo may not always be the best choice. 

Now, the potential benefits are significant if you have an offer for a fresh personal loan at an interest rate of 10.5 percent.

Raising personal loan to retire the current debt

1. A new loan with more favourable terms can reduce your overall interest payments. 

2. A fresh loan with a lower amount and better terms may result in lower monthly EMI due to a restarted tenure. 

3. Consolidating multiple loans into one can ease the burden of handling numerous loan payments.

4. Personal loans are unsecured loans, meaning you do not need to provide collateral.

“Sometimes people follow the rule of thumb where they are told to avoid taking a loan to repay a loan. However, there could be certain situations where this may be favourable, particularly when the rate of interest is lower, and the processing fee does not negate the saving,” says Deepak Aggarwal, a Delhi-based chartered accountant and wealth advisor.

“However, the borrower must ensure that there are not too many hidden costs or a high cost of processing the loan. The one-time cost can be staggered to compute the monthly cash outgo. That is the way to do a fair comparison,” he adds.

Things to be careful about

1. Processing fee: Ensure that the processing fee is nominal and does not wipe out or offset the savings from consolidating your debt.

2. Hidden costs: Some banks may levy hidden fees or costs to woo new clients. Be careful about such charges before committing to a new loan. 

3. Fixed or variable interest: Be aware of whether the interest rate is fixed or variable. A variable rate would increase as the interest rates rise, affecting future payments. So, the interest rate ought to be fixed for a fair assessment.

4. Reputation of bank: Switching to a smaller financial institution to save little money is not advisable. Consider sticking with established banks with extensive branch networks and efficient customer service unless the cost savings from a smaller institution are substantial.