Five popular but terrible misuses of personal loans

by ValuePenguin

The rise of household debt has been a big issue in Singapore. Due to lackluster real income growth compared to the rate of inflation, consumers have been borrowing more to fund their consumptions. While this has been particularly case for expensive purchases like cars, it has also led to rise of personal loans. For instance, Google's study of financial markets in Asia shows that personal loan was the most searched financial product in Singapore in Q4 of 2016.

A quick search around the internet, however, reveals that people might have huge misconceptions about how to properly use personal loans. Therefore, our team at ValuePenguin prepared the below study to demonstrate why you should never use personal loan for certain purposes, and which usage areas are more appropriate for using personal loans.

5 Popular Usage of Personal Loans That Are Actually Counter-productive

Some of the popular use cases for personal loans include the following:

  • Home renovation project
  • Education
  • Paying off credit card balance/debt consolidation
  • Temporary funding for an inconsistent or late paycheck
  • Big purchases (i.e. cars, luxury items, vacations)
  • Weddings
  • Medical expenses

While this list is not comprehensive, there are several items here that are actually not quite ideal for using personal loans as a financing option. Namely, they are home renovation project, education, debt consolidation, temporarily making up for late paycheck and big purchases. Of these, there are better alternatives to a personal loan for the first 4, while using a personal loan to make a big but unnecessary purchase is just generally ill-advised.

Let us demonstrate our case with real life examples. For most of these use cases, banks provide a more specialised loan product with lower costs. For example, renovation loans that can only be used for home improvement projects cost only about 5% per year, which is about half to a third of what an equivalent amount of personal loans would cost.

Use Case Cost of Personal Loan Better Alternatives
Home renovation project 13-15% per year of Effective Interest Rate Renovation loan: 5% per year
Education Education loan: 4-5% interest rate + 2% fee
Car purchase Car loan: 4-5% effective interest rate
Paying off credit card balance/debt consolidation Debt consolidation loan: 8.5-10% per year
Temporary funding for an inconsistent or late paycheck Personal line of credit: 20% interest only on the amount you borrow at any given time

Even if you were to use personal loan as a "supplementary" loan on top of your normal renovation loan or car loan, we think such a move is generally not a good idea. If you are trying to or spend more than you are able to afford, taking out a 10% interest rate loan just so you can satisfy your urge for vanity is an extremely expensive exercise.

Personal loan's inefficiency for the last use case is also worth pointing out: getting temporary funding to last a few days (or weeks) when your income is inconsistent (i.e. you are a contractor, etc.). Let's say you need to borrow S$3,000 from the bank to last a month before you get your paycheck. One option is to borrow S$3,000 from Citi as a personal loan with a tenure of 1 year, which costs S$0 in processing fees and 4.94% in flat interest rate. Another option is to get Maybank's CreditAble personal line of credit for 1 month, which costs 9% in interest rate and S$0 in annual fee. By calculating the total cost that you would have to incur on both of the options, it's easy to tell that the latter is undeniably the cheaper option for you.

What You Should Use Personal Loans For

Still, this does not mean that a personal loan is not good for everything. In fact, it's actually quite useful for big purchases that are important and unavoidable. For example, if you have a medical emergency that costs more than you are able to afford, a personal loan can help you spread out the financial burden by dividing your repayment into a regular monthly schedule. Similarly, one-time purchases that are unavoidable like weddings are generally a good use case for getting a personal loan.

This is another reason why you shouldn't use personal loans for any vanity purchases. If you borrow too much, you can trigger restrictions like total debt to service ratio, which can prevent you from getting financing when you really need it, like when you have a medical emergency or when you are trying to get a home loan.

Therefore, it's generally a good idea to avoid using this relatively high cost debt until you really need it for an avoidable large expenditure that you can't immediately afford.

This article was first published at ValuePenguin

This entry was posted in Finance.
This entry was posted in Finance.