If you are considering taking out a personal loan, you must understand how this type of loan works. Personal loans are flexible; they can be used for a variety of purposes, such as consolidating debt, financing a home improvement project, emergency expenses and or paying for a vacation. In addition, personal loans typically have lower interest rates than credit cards and other types of loans.

As long as you’re responsible and have a plan to pay it back, debt can help you reach your financial goals. If you work with a reputable lender, use the loan for the right reasons and fully commit to paying it back, then a personal loan can be a smart option.

What Is a Personal Loan?

Personal loans are a lump sum to be paid back in fixed installments over a predetermined length of time. They can be secured, or unsecured and repayments include interest and any fees. Personal loans are usually repayable over a few months to a few years.

An unsecured personal loan has no collateral; you do not have to put up property such as a car or house that the lender could seize if you default on the loan. Therefore, the lender is taking a greater risk and will most likely charge you a higher interest rate than it would with a house mortgage or car loan.

  • Personal loans can be used for a variety of purposes.
  • Personal loans typically have lower interest rates than credit cards and other types of loans but can be more expensive than others.
  • Personal loans can help you consolidate debt, finance a home improvement project, or pay for a vacation.
  • Personal loans typically have a fixed interest rate, which means your monthly payments will stay the same throughout the life of the loan.
  • Unlike home mortgages and car loans, personal loans are usually not secured by collateral.
  • Before taking out a personal loan, make sure you understand the repayment terms.

Reasons to get a personal loan and when they make sense.

Not all debt is bad. Sometimes a personal loan can make sense if you need to pay down debt through consolidation or need to make a big purchase that you don’t want to put on a credit card.

When to Consider a Personal Loan

  • Debt consolidation: This is a loan, ideally at a lower interest rate, to pay off other loans. Combining all your outstanding debt into one monthly payment simplifies payments and time frames. Before you do take out a loan, however, check there are no prepayment penalties on the old loans as those fees can sometimes be quite high.
  • Consolidating credit card debt: If you owe on credit cards with high-interest rates, taking out a personal loan to pay them off could save money. With lower interest rates, you can reduce the amount of interest you pay and the amount of time it takes to pay off the debt.
  • Holidays: Using a personal loan to pay for a holiday might work if it stops you from mindlessly spending as you might with credit cards. Getting a lump sum can help prepay for certain expenses such as hotels, and flights. However, if you do take out a personal loan to get to your dream destination, just know you’ll be paying off your holiday over several years.
  • Wedding expenses: Weddings can cost loads and take tons of preparation. For instance, you may need to make deposits way in advance to secure catering or a venue. A personal loan can help you avoid dipping into your savings or emergency fund, but if you are considering one, do try to come up with a realistic wedding budget first.
  • Home maintenance and repairs: Homeowners can use personal loans to upgrade their home or carry out repairs like plumbing, wiring, or the roof. However, if you do have any equity built up in your home, adding to an existing mortgage could be less expensive.
  • Large purchases: If you suddenly need to buy a new washing machine or a new set of tyres for your car but don’t have the funds, taking out a personal loan could be cheaper than financing through the seller or putting it on a credit card. It will let you cover costs immediately and although you’ll have to pay interest and potentially upfront fees, a personal loan can save you time and money.
  • Vehicle financing: A personal loan is one way to cover the cost of a car, boat, trailer or motorhome if you’re buying a used car directly from its owner. It might also be a better bet if you’re purchasing a car from a dealership as you could get a lower interest rate.
  • Emergency expenses: Personal loans help cover an emergency, like paying for a funeral or surprise medical bills because they can be accessed so quickly.

When you take out a personal loan to pay off credit cards, make big purchases or hold a big wedding, you are borrowing money that must be repaid with interest on top. You should always borrow responsibly.

When is a personal loan a bad idea?

While a personal loan is useful for large or unexpected expenses, there are some situations where it may not be such a great plan:

  • You can’t afford the monthly loan payments. If you’re on a tight budget, a personal loan may not make sense.
  • You can access better financing options. If the loan is for a purchase that would qualify for a different loan type, such as a mortgage, car loan or student loan, you could be better off with a loan designed specifically for that purpose. Most banks have an overdraft option so account holders can withdraw more than they currently have in their accounts. An overdraft might be feasible if you need money for a short period – until payday for example. However, make sure to read the fine print about what you may be charged as penalties can be high, particularly if you go into overdraft without pre-approval.
  • The expense isn’t necessary. Getting a loan for something that isn’t necessary can put your finances at risk. If you have limited cash flow or an irregular income, it might do you more harm than good
  • Managing debt is tricky: While debt consolidation loans can lessen your debt burden, you have to commit to not taking on any more, and you’ll need to be prepared to make payments on that debt for a few years.

How to get a personal loan

If you’ve looked at the options, and decided on a personal loan, here’s how to find the best loan for you:

  • Estimate your payments: Use a personal loan calculator to estimate the interest and monthly payments and factor those payments into your budget to ensure you can afford the loan.
  • Compare rates across lenders: Be sure to shop around and compare interest rates and terms from different lenders.
  • Look at loan features: Some lenders offer flexible payment schedules that allow you to change a due date or pay off your loan faster.
  • Read the fine print: before signing the dotted line, you must know exactly what you’re getting into.

Taking out a personal loan shouldn’t be taken lightly

Taking out a personal loan means taking on debt, and no matter your circumstances, the loan must be paid back. Carefully consider your financial situation and if you don’t have the budget or the discipline, reconsider borrowing, if you can. Saving is often the best, and cheapest, way to pay for some things. However, if you do need to borrow, and your income is stable enough to commit to a few years of monthly payments, then a personal loan can be cheaper and more manageable than borrowing on credit cards.

Personal loans can be a great way to finance a variety of expenses. With careful planning and budgeting, a personal loan can help you reach your financial goals, but you must understand the terms and consequences before doing so.

For information on independent confidential budgeting services or advice, visit www.moneytalks.co.nz.