What You Can Learn About Personal Loans

What You Can Learn About Personal Loans

Whenever you contemplate taking out a personal loan, think very carefully why you are doing it because most purchases financed through personal loans leave you with no real asset, only a debt. If, however, after coolly thinking it through, you decide you must have the item, then go ahead and take the loan, but make sure you shop around - interest rates and conditions on personal loans vary considerably

Always try getting finance from a bank, building society or credit union first as their rates should be significantly lower than those of a finance company, sometimes dramatically so.

Also note if the interest rate quoted to you is a flat rate or a reducible rate. Most loans are reducible, but you can't assume this. A flat rate of 8% from a finance company may look better than a reducible rate of 11 % from a credit union - until you realise that an 8% flat rate may be equivalent to a 15% reducible rate in terms of total interest paid over the life of the loan.

The rate of interest offered to you, no matter who the lender is, depends on the lender's perception of the risk of the loan application. The riskier it is perceived  to be, the higher the interest rate offered - if, indeed, a loan is offered at all. The factors that go into the lender's estimation of the loan's risk include an appraisal of you the applicant, and of the item you wish to purchases. Loans for second-hand cars, for instance, often attract higher rates than loans for new cars.

The personal information the lender may want will include your employment record, your income, your age, whether you own a home or rent one, what assets you have and so on. The information required about the intended purchase can vary from being quite detailed to none at all.

Personal loans are normally repayable over three or seven years, though it can be longer or shorter. They can be variable or fixed rate and can be secured or unsecured.

Secured vs Unsecured Loans

A secured loan is one where the lender takes additional security over another of your assets - one worth more than the value of the loan.

An unsecured loan is one where the lender takes no security other than the item you are buying. Because of the relatively high risk to the lender, unsecured loans are offered at higher interest rates.

In the event you default on a secured loan, the lender has the debt. If you default on an unsecured loan, the lender can take back the unsecured item (if it still exists) and sell it. However, if this doesn't cover the outstanding debt, you may be obliged to sell other assets to make good the debt. Of course, the unsecured lender can't take possession of your assets willy-nilly and sell them from under you. Well, not without bankrupting you first. 

Borrowing On the House

There is another way of structuring a personal loan, and that is by having the amount you wish to borrow added to your mortgage, thereby taking advantage of mortgage interest rates which are traditionally the cheapest form of debt. So, if you wanted to borrow $10,000 for a holiday (which is not recommended) you could “put it on the house” by increasing your mortgage by $10,000. Hey Presto! – here’s your low-interest financing. The big problem with this, though, is that the $10,000 holiday could end up costing you a small fortune.

Let’s say you had a $100,000, 25-year mortgage and you added $10,000 to it the end of Year 1. Assuming an average 10% interest rate throughout the life of the loan and adjustments to the payments to repay the loan in the original term, it would add $16,421 in interest repayments to your mortgage over the remaining 24 years. It would certainly want to have been a damn good holiday at the price!

Look, if you have to borrow money it’s obviously best to do it at the lowest interest rate possible. But don’t fool yourself by borrowing money to buy things like a holiday (which is worth nothing the moment you get back), a stereo, clothes or furniture (which are practically worthless after three to five years). Unless you are very disciplined, using your home loan to buy consumer items is crazy – you may still be paying a fortune for the items 25 years later and long after they have turned to dust

Cash is King

No matter what type of loan you use it’s important to realise there’s a big price penalty you pay for debt financing. A hi-fi system priced at $5,000 bought with a personal loan at a reducible interest rate of 15% p.a. over five years would cost you $7,137 ($2,137 in interest). With cash, on the other hand, it would cost $5,000 at most, probably even less with the discount cash can often attract.

When You Take Out a Personal Loan

Avoid taking out a personal loan to finance consumption if at all possible. But if you must, make sure you can comfortably answer the following questions before you sign up.

  • What is the interest rate?
  • How long will it take to pay the loan off?
  • Can I afford the weekly repayments?
  • If I get a wage rise can I pay the loan off faster?
  • Are there any penalties if I fall behind with my repayments?
  • Do I really need this Item?