Buying something via a personal loan is more expensive than making the same purchase direct from money that you have in your checking account. Therefore, as a starting point, a personal loan is a bad idea if you can comfortably afford to purchase the item from existing liquid funds. However, there are some occasions, when we don’t have a ready availability of sufficient cash, where a personal loan may be a useful way of financing a necessary expense. For example, many of us employ a personal loan when purchasing a car. There are some circumstances however where a personal loan can be a bad idea and may lead to financial problems.
Ability to repay the loan:
A personal loan is a bad idea if you aren’t sure that you can comfortably afford to make the repayments. It is a bad mistake to stretch your finances to their breaking point. This is a lesson that some of our banks have been learning the hard way recently, never mind individuals! You should remember that some of your existing regular expenses may increase, so you need to allow for that eventuality when planning your finances.
Using a personal loan as a way to live beyond your means:
The idea with a loan is that it is a means of paying now for an item that you are then going to repay in a set amount of months. However, in order to be able to repay the loan , you need to be acquainted with the principle of spending less than you earn. Some people fall into the trap, with credit cards, overdrafts and loans, of using credit to finance a lifestyle that their income doesn’t support. The problem with this is that it’s building up trouble for the future and, at some point, the chances are that you will default on the loan and/or be declared bankrupt.
Using a personal loan for things that aren’t essential:
Most of us would agree that using a personal loan to buy a car or finance our education can be a good thing. You may need a car to commute to work or to get the kids to school. And by taking a loan to finance those professional qualifications you are investing in your future and this will hopefully enable you to get a higher paid job in the future. However, there are some loan purposes that are more doubtful. For example, I’m not convinced that taking out a loan to pay for a holiday or to fund your daily expenses is a good idea. You might be better to plan ahead, and put aside a little money each money, so that you can afford a holiday without having to resort to a loan.
When the interest rate is high/uncompetitive:
I’ve already pointed out that loans are an expensive way to pay for things. It’s therefore vital that you at least ensure that the loan that you apply for has a low interest rate. One problem that individuals sometimes face is where banks employ risk based pricing. This is where the lender offers lower rates to people with a good credit rating and higher rates to people with less good credit rating. The idea (from the lender’s perspective) is that the people with a good credit rating are less risky and should be rewarded for this. However, it can mean that some people with less good credit histories are forced into accepting a loan at a high rate of interest which can lead to problems. Payday loans (in the US) are another example of a type of loan that often is costly for an individual to pay back.
Where there is more at risk than just your credit rating:
Most loans are unsecured. This means the worst that can happen if you default is that you will incur bank fees and damage your credit rating. This, in turn, may have serious consequences, such as an inability to be approved for a mortgage. However, even worse would be to default on a secured loan where the loan has been agreed subject to the proviso that it is secured on your home or some other asset. If you end up having to default on the loan, then the lender is entitled to sell your asset which would be a disaster.
If you suspect that your job could be at risk:
In normal times, I probably wouldn’t have included this point. However, in the credit crunch fuelled recession we’ve seen so many people losing their jobs that it warrants inclusion. If you’re working in an industry (or for a company) whose prospects are looking uncertain, then now may not be the best time to commit yourself to a loan. Indeed, what we usually see during recessions is that people cut back on big ticket purchases (such as cars) and decide to get by without the need for a loan.
Summary:
Loans aren’t inherently evil. Indeed, they can be extremely useful in some circumstances. However, like all forms of credit, they do come with a risk warning, namely that failure to repay them will damage your credit rating and may result in some other nasty consequences such as incurring bank charges. That’s not to mention the emotional stress that will result if you do get into difficulty on repayment. The key, therefore, is to carefully assess whether you need to make the purchase, whether a loan is the best way to finance that purchase and ensure that you’ve shopped around to get a good rate. Once the loan has been taken out, you should make sure that you are setting aside enough each month to comfortably make the repayments and you should have allowed enough leeway to be able to cope with any unexpected increases in your regular expenses. If you’ve done all this, then hopefully you will have no difficulties and will be able to enjoy your new car or whatever else you’ve used to loan to buy!