At some point in our lives, most of us experience money stress. Often this can show up through rising rent, unexpected medical bills, car repairs, or simply overspending.
In such circumstances, taking out a personal loan can be a decent short-term option. Especially if we don’t have enough savings or sufficient cash flow to cover this extra expenditure.
However, while they can help in some situations, they also carry risks that you might not be aware of. That is why it is essential to practise responsible borrowing.
To do this, you need to know how personal loans work, what they really cost and the implications of not being able to repay them. This guide will help to improve your understanding.
What is a personal loan?
A personal loan is money that you borrow from a lender and repay over an agreed period of time, with interest, through regular repayments. In Australia, most personal loans are unsecured personal loans. This means you do not need to offer your house or car as security. Instead, the lender relies on your income, credit history and ability to make repayments as the determining factors of whether they will loan you money.
Some lenders also offer personal loans for bad credit. This is aimed at people who have struggled with repayments in the past or have marks on their credit file. Such loans usually come with higher interest rates and stricter borrowing terms.
Typically, repayments are made on a weekly, fortnightly, or monthly basis. They also generally include both interest and part of the original loan amount.
Why do people take out personal loans?
People choose to take out personal loans for a wide range of reasons. Some of the most common include:
- consolidate their debts;
- renovate their homes;
- fund a wedding, holiday or purchase of a new car; and
- unexpected emergencies (such as medical bills and repairs).
They can be seen as an attractive proposition, in particular for those who want the certainty of fixed rates and predictable payments. They also provide faster access to cash than savings kept in term deposits and ensure that they are not depleted.
Understanding interest rates
Interest rates are always in the news, mainly because the RBA meets eight times a year to set them. Often, they are the first thing people notice when comparing personal loan options (the current cash rate at the time of writing is 3.6 per cent). But they are only one part of the picture.
The true cost of a loan includes the interest that is accrued over time. It also encompasses fees charged by the lender, including establishment fees, monthly account fees and late payment penalties.
The total cost of a loan can therefore be much higher than expected. In particular, when repayments are stretched over several years. That is why borrowing money responsibly means looking beyond just what feels affordable today. It should also consider how repayments will affect your finances in the long term.
Fixed vs variable interest rates
Essentially, lenders offer two types of interest rates: Fixed or variable. This gives borrowers a choice between predictable payments and flexibility.
The main difference between the two is that a fixed interest rate stays the same for the entire life of the loan. This makes repayments predictable and can help people budget more confidently. By contrast, a variable interest rate can change over time. Subsequently, repayments may increase if interest rates rise. But they also might go down if the rate falls.
Both options have their advantages, yet also involve trade-offs. For instance, fixed rates offer stability but less flexibility. Variable rates, on the other hand, can start lower but carry uncertainty.
What does responsible borrowing really mean?
The concept of responsible borrowing revolves around understanding your financial limits and respecting them. Essentially, it means borrowing only what you can afford to pay back in the agreed upon timeframe. It also means being realistic about how repayments will affect your everyday life.
In addition, responsible borrowing requires not just understanding the consequences of missed payments, but recognising when borrowing may create more problems than it actually solves.
What happens if you miss repayments?
If you miss repayments on your personal loan, you will face immediate consequences. They typically include reminder notices, late fees and a negative credit score. The latter of which might impact your ability to borrow money in the future.
Should you continue to miss repayments and fall into debt, you can face escalating actions. They might include receiving formal default notices, the potential repossession of your assets (for secured loans) and aggressive debt collection actions. You may even face legal action, or your lender might sell your debt to a third party.
If you are experiencing any issues with making your loan repayments, it is vital that you contact your lender. They often have measures in place, such as hardship options, that can prevent default listings and credit score penalties.
How to assess whether you can afford a personal loan?
Before taking out a personal loan, you should take the time to fully assess if you can afford it. Just because a lender is willing to advance you the money on minimum criteria, it doesn’t mean you can manage the repayments. Only you can decide how much taking out a loan will affect your everyday life and overall financial position. This is especially pertinent to young people who might still have HECS debts from university.
For instance, if after making the repayments you have no money left for emergencies or basic living expenses, then it might not be the wisest course of action.
What common mistakes do people make when taking out personal loans?
Unfortunately, many people run into trouble when taking out personal loans because they assume that being approved for a loan means they can afford it. However, borrowing the maximum amount offered can quickly place immense financial strain on them. This is particularly true if their income changes or the cost of living rises.
Often, people rush into a loan because of the circumstances they find themselves in. This could lead them to make poor decisions that ignore the total cost of a loan and result in them paying far more than they expected over time.
Additionally, some borrowers get into trouble by taking out more than one personal loan. Or, for that matter, take out one, without really understanding the terms and potential consequences involved in doing so.
