Personal loans, which are unsecured installment loans, are becoming increasingly popular because of their relatively low interest rates compared to other borrowing alternatives like pawnshops or moneylenders. While personal loans can be used for almost any purpose, some use cases are more financially sound than others. Importantly, taking out a personal loan should lead to either an immediate or a long-term economic benefit. Here’s a look at when taking out a personal loan makes sense--and, just as importantly, when it doesn’t.
Consolidating or Paying Off Debt
Consolidating or paying off high interest debt like credit card bills is not only the most common reason people turn to personal loans, but also one one of the smartest. A personal loan allows you to streamline multiple debt obligations into a single monthly payment with a lower interest rate than you would otherwise have to pay. Many credit cards, for instance, have APRs of 25% or higher. In contrast, debt consolidation plans (a specific branch of personal loans) can have rates as low as 5% to 6%. By dramatically reducing your interest burden, a personal loan can have an immediate economic benefit to your daily finances.
Using a loan to make a long-term investment qualifies as “good debt,” as long as the said investment can yield in an oversized return. For this to work properly, you need earn more than you’re borrowing in the long run. Renovating your home, for example, can be a very effective way of increasing the value of your home. In this case, you can utilise a type of personal loan called renovation loans to finance your home refurbishing project. If you need to spend S$50,000 on your renovation but you only have S$20,000 of extra cash, you could take out a renovation loan of S$30,000 at just 3% to 4%. As long as your home's value increases by more than S$50,000, this project could definitely be worth taking out such a cheap loan that can cost you as little as a few hundred dollars in interest.
Career or Educational Development
Like borrowing to renovate, using a loan to invest in your career or education could reap dividends down the road by raising your qualifications and boosting your income. For instance, ValueChampion's study found that post-secondary education can result in income that's almost 2x higher than it is for people without a post-secondary education. To help you finance your university education, most of the banks in Signapore offer very attractive rates on their study loans. Not only that, even personal loans can be used for other educational or professional-development endeavors like programming bootcamps. If such endeavors can get you jobs (especially high paying jobs), the cost of a few hundred to thousand dollars in interest could be well worth the pain.
When Should You NOT Use a Personal Loan?
While a personal loan can be used for virtually any purpose, there are instances where a personal loan isn’t the best financing option. Mostly, these are use cases that do not generate any economic benefit to the borrower. Here are a few of those:
Weddings, Honeymoons or Vacations
Taking on debt for these, or almost any other consumer products or expenditures, is generally a bad idea. Not only will you be stuck paying for your vacation or wedding for years to come, but this strategy also encourages bad financial habits, since it’s better to save for such expenses than to borrow for them. Most financial experts agree that if you probably can't afford loans if you must borrow to pay for your wedding in the first place. If you must borrow to finance your dream wedding or honeymoon, keep it to a minimum and consider reducing your budget down a notch.
Faced with a hefty medical bill, a personal loan may seem like a godsend. However, there are several reasons to pause before even considering such a loan. The first is that you can usually work out a payment plan directly with your medical provider, thus allowing you to skip paying interest on the debt. Further, medical bills sometimes evolve downward as all-too-common errors are found and some bills can even be negotiated. If you take out a personal loan only to find you owe less, you’ll be stuck paying interest on the extra amount.
Car Purchase or Refinancing
A personal loan can be used to buy or refinance a car, but it isn’t an ideal option. You’re better off getting a traditional auto-purchase or auto-refinancing loan. Because these loans are secured by collateral, your car, they have lower interest rates than personal loans, which are unsecured. For comparison, we found that for an average personal loan cost 13-15% in annual interest while an average auto loan cost about 3%.