Once in awhile, I received offers from banks to lend me personal loans. The rates sometimes can be attractive (almost the same rate as fixed deposit interest rate) and sometimes can be exorbitant. In this article, we shall discuss about this type of loan.
Pros of personal loans
1. No collateral required
Most personal loans are unsecured, meaning you do not have to pledge any assets like your home or car as collateral. This reduces the risk of losing valuable property in case of default.
2. Flexible usage
Personal loans can be used for various purposes, such as consolidating debt, funding a wedding, covering medical expenses, or financing home renovations.
3. Fixed interest rates
Many personal loans come with fixed interest rates, providing predictability in monthly payments and helping with budget management.
4. Fixed repayment terms
Personal loans usually have fixed repayment terms, typically ranging from 1 to 10 years. This allows borrowers to plan their finances accordingly.
5. Quick approval and disbursement
Personal loans often have relatively quick approval processes, especially if you have a good credit score.
6. Improves credit score
Timely repayment of personal loans can help improve your credit score, which can be beneficial for future borrowing.
Cons of personal loans
1. Higher interest rates
Personal loans generally have higher interest rates compared to secured loans (like home loans) because they are unsecured.
2. Debt accumulation
If not managed properly, personal loans can lead to increased debt burden. Borrowers might find themselves in a cycle of borrowing and repayment.
3. Fees and charges
Personal loans can come with various fees, such as processing fees, early repayment penalties, and late payment charges. These can add to the overall cost of the loan.
4. Credit score impact
Applying for a personal loan results in a hard inquiry on your credit report, which can temporarily lower your credit score. Additionally, missing payments can significantly damage your credit rating.
5. Repayment burden
Fixed monthly repayments can become a burden, especially if your financial situation changes unexpectedly, such as job loss or medical emergencies.
6. Strict eligibility criteria
Lenders have stringent eligibility criteria, including minimum income requirements and credit score thresholds, which can make it difficult for some individuals to qualify.
Interest rate of personal loans
The interest of personal loan is charged using flat interest rate. The interest is calculated for the whole loan amount at the beginning of the loan tenure. Regardless of how much of the principal you have repaid, the interest charged remains the same for each payment period. This means that the total interest paid over the life of the loan remains constant.
When the loan is being offered, an interest rate will be quoted and this is known as nominal interest rate. This interest rate may be so low that it makes no sense for us not to take advantage of it. However, the low interest rate could be a trap. Once the tenure of the personal loan is more than one year, we should use effective interest rate to get the true interest rate of the loan (click here to learn more about the different interest rates).
Let’s assume the interest rate of the loan is 3% per annum. If the tenure is five years, the effective interest rate is 5.64%. If the tenure is 10 years, the effective interest rate is 5.46%. I am using the online calculator of loanstreet (click here). Thus, the true interest rate will be higher than the advertised interest rate.
Conclusion
Personal loans offer a convenient solution for financing various needs without the need for collateral. However, they come with higher interest rates and potential fees that can increase the cost of borrowing. It is essential for borrowers to carefully assess their financial situation, compare different loan offers, and read the terms and conditions thoroughly before committing to a personal loan.
Whether the personal loan is good or bad, it depends on the purpose of the loan. The loan is inherently neutral. If you are able to use the money to earn higher return than the interest rate, it will be a good move. On the other hand, if you use the money for personal enjoyment, this will certainly have some negative impact on your finances. Given the high interest rate involved, it might not be a good idea to borrow personal loans for most people. Proper financial planning and responsible borrowing are key to making the most of personal loans while avoiding potential pitfalls.
How can a financial planner help you?
If you are thinking of taking on a loan, I could run the numbers for you and see if your cash flow can afford it. Even if you can afford it, we shall see if the total amount payable will make it worthwhile. Furthermore, we can discuss the necessity of taking the loan.
If you currently have loans, I will make a list of your current debts and devise a debt management plan for you. You should decide whether the snowball method or avalanche method is to be used (click here to learn more about these two methods). As it is your own finances, you are the ultimate decision maker. Even if the plan is perfect, it would not work if you do not implement it. So, let me know your preferences and select a plan that you would implement wholeheartedly.
If you really cannot follow the plan, do not worry and let me know as soon as possible. I will come up with alternatives. Nonetheless, if you always fail to adhere to the plan, perhaps the plan needs to be overhauled. I will help you with this. I will also refer you to the appropriate party to seek help if your situation warrants it.
If you are interested in working with me to improve your finances, just leave your details by clicking the button below. I will reach out to you and see if we would be a good fit for each other.
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Disclaimer: This post is for informational purpose only. You should use judgment and conduct due diligence before taking any action or implementing any plan suggested or recommended in this article.