Personal Loans are one of the easiest loans to understand. You need money to fund a new kitchen, to pay for little Sarah’s school fees, to buy a boat, and so forth – so you put your hand out to the bank and they might be generous enough to extend assistance via a personal loan.
But banks don’t just give you the money. They’ll charge interest on the money lent, and the loan (plus interest) must be paid back over a set period of time. Most lenders will allow you to pay more than the minimum repayments to shorten the life of the loan and the overall interest that you pay.
Secured or Unsecured
A personal loan can be secured or unsecured. Which is better? Well, if you can secure a personal loan via a house, car, term deposit and so on, interest charges on the loan will typically be less – which is a good thing. But remember, if you default on your loan repayments, the bank will be looking to take the security (car, term deposit and so on) off your hands as pay back, so don’t take this loan obligation lightly.
Unsecured personal loans are much riskier for the bank and therefore they’ll charge you higher interest to cover the risk that you don’t pay the loan back. And fair enough.
Personal loans are often used to consolidate debt. Let’s talk about typical, but fictitious shopper Jenny. She has two credit cards, totalling a whopping $8,000 and she’s fast sinking into debt. Interest costs on her credit card is a frightening 18%.
In this situation, Jenny has two options. She can transfer her debt to another credit card offering a nil interest introductory period (sometimes for as long as 6 months). If she believes that she can knock off the debt over this period of time, then this is probably the best move. (Remember: after the introductory period ends, the interest charges start again and can actually be higher than normal. So watch out.)
If Jenny estimates that 6 months isn’t long enough, she might be well advised to take out a personal loan – pay out the credit cards (and close them!) – and then start tackling the interest payments on the personal loan. That’s because the interest costs on a personal loan are typically lower. Plus, a strict repayment schedule on a personal loan will give Jenny the discipline she needs to save.
Buying stuff using a credit card versus taking out a personal loan
Most people wouldn’t take out a personal loan to buy clothes, for example, or smaller items like Christmas presents. Personal Loans are generally reserved for bigger purchases like home renovations, a car, an overseas trip and so forth.
Credit cards are handy for those everyday expenses. You use the card to pay for dinner at a fancy restaurant, and a couple of other monthly luxuries, and then you pay off the credit card before the end of the month. Next month, you start charging up your credit card again – and this spending and paying-back routine can go on forever.
Personal loans, on the other hand, are for a fixed term, and the lender expects you to pay it all back by the end of the term. Application fees on personal loans are higher than credit cards and other annual fees can add up. Taking out a personal loan is therefore a more complicated process so it’s not really suitable to fund short-term random spending.
So when comparing personal loans to credit cards remember to take into account application fees, interest charges and any other annual fees.
Fixed or variable rates – which is better?
Taking out a fixed-rate loan gives you the security of knowing how much your interest payments will be for the life of the loan – which is good from a budgeting standpoint. If the Reserve Bank of Australia (RBA) hikes rates – who cares? You’re safe from the pain of higher rates. On the downside, if interest rates fall over the loan period, then you don’t benefit from cheaper funding.
A possible downside of a fixed-rate loan is that some lenders punish you for paying off the loan earlier than the term, and there can be restrictions on making extra repayments to pay the loan down early. Take these important restrictions into consideration when signing up.
Variable rate loans are generally more popular than fixed rate loans simply due to the flexibility they offer. Want to make extra repayments or pay off the loan early – many variable rate personal loans don’t charge you a penalty fee for doing so. But any RBA hikes over the period of the loan will show up in your account statement.