Taking out a loan is one of the most powerful and dangerous financial decisions a person makes in his lifetime. By providing funding when you most need it, a loan allows you to do things that you wouldn't otherwise be able to do, like buying a home that costs more than your savings or paying for a medical emergency. But, it can also lead to financial ruin if not done properly. For people who have not taken out a loan before, all the different types of loans, interest rates and fees, getting the best loan for their needs can be quite confusing. Below, we walk you through each of the major decision steps when choosing a loan. Read on to learn how you can optimise your finances.
Table of Contents
- Loans for Different Purposes
- Understand How Interest Rate Works
- Balance Between Maximising Your Loan and Minimizing Interest Payment
Use Specialized Loans Whenever Possible
In Singapore, there are five main types of loans for consumers: home loans, car loans, personal loans, education loans and renovation loans. As a general rule of thumb, you should always get the most specific loan possible. Banks charge higher interest rate for riskier loans, and it is usually considered to be safer when banks know what you are going to use the money for. Hence, if you know you need funding specifically for purchasing a home or car, or for financing your home renovation or college education, you should always get the loan specifically designated for each of these purposes.
Personal loans are the only exception to this rule. Because this loan is available for anyone with sufficient income, you can use it to do anything you want with it, i.e. funding your wedding, honeymoon, medical emergency, business emergency, etc. However, banks also compensate for this flexibility by charging you the highest interest rate among all the loan products available. Therefore, it should generally be considered as a last resort of funding, though it is generally better than other less conventional options like credit card debt, payday loan or cash advances.
Finally, you should always shop around and compare the best offerings from each bank. Our team at ValueChampion has painstakingly combed through all the loan products available in Singapore to present you with options that represent the best value in the country. You can visit any of the following links to start comparing now:
Loan Offerings in Singapore by Type
Compare Interest Rates Correctly for Different Types of Loans
Banks are always advertising "low" interest rates coupled with confusing terms like annual interest rate, effective interest rate, flat rate and rest rate. Because you have to go back and forth among these words, comparing different loan offerings from different banks can be quite painful at times. What is important for you to know here is that you should be comparing effective interest rates between banks no matter what loan it is. Below, we discuss how to estimate the effective interest rate for each type of loan.
In general, "safer" types of loans like home loans, home renovation loans and education loans come with a type of interest rate called "rest rate." This is the conventional interest rate that is charged monthly on the amount of money you have not repaid to the lender. In one month, you may pay 2.5% on a S$50,000 loan. After you pay down the loan by S$10,000 next month, you will only have to pay the interest of 2.5% on the remaining balance of S$40,000. To estimate effective interest rates for rest rate loans, you just have to combine the effect of bank's processing fee to the interest rate. If this is too difficult, you can easily just compare the processing fees and rest interest rates separately.
On the other hand, risker loans like car loans and personal loans typically come with a rate called "flat rate." These loans charge a fixed % of interest on your loan every single month no matter how much of the loan you've repaid. In one month, you may pay 2.5% on a S$50,000 loan. But even after you pay down the loan by S$10,000 next month, you will still have to pay the interest of 2.5% on the original S$50,000. In order to calculate EIR of these loans, you have to convert the flat rate into its equivalent level of a more "intuitive" rest rate, and then account for the impact of processing fees.
If you want to learn how to actually calculate and compare rest and flat rate, you can read our guide on annual interest rate and effective interest rate. The key takeaway here, however, is that you should be comparing EIR of every loan so that you are comparing the total cost of each loan on an apples-to-apples basis.
|Loan Type||Interest Rate Type|
|Home Loans||Rest Rate|
|Home Renovation Loans||Rest Rate|
|Education Loans||Rest Rate|
|Car Loans||Flat Rate|
|Personal Loans||Flat Rate|
Balance Between Maximising Your Loan and Minimizing Interest Payment
Last but not least, one of the most important things you can do when choosing a loan is maximising the amount of loan you borrow (so you can get sufficient funding for whatever you need to do) while keeping your monthly installment at a very manageable level. It's a fine balance between getting the most amount of funding while minimising what you have to pay out to the lender every month.
It's not always about Total Debt Servicing Ratio (TDSR) or Loan-to-Value Ratio (LTV)
The main way you can do this is by first calculating how much of your monthly income you can set aside for servicing all of your loans. Generally, the Monetary Authority of Singapore requires the total debt servicing payment to be 60% of your monthly income at most (also referred to as Total Debt Servicing Ratio - TDSR), though this rule doesn't necessarily apply for people who are refinancing their home loans. However, we recommend not maximising on this 60% since you should leave some margin for error so that your budget can handle the total sum of your loan repayments even if interest rates rise.
Then, you want to look for loan offerings that comes with the monthly repayment (principal + interest) at or below the amount you calculated for yourself above. Generally, most loans come with a maximum principal amount ratio that they are willing to allow, often in a form of loan-to-value (LTV) or multiple of your salary. For example, car loans come with a 70% LTV ratio limit, meaning you can only borrow up to S$70,000 for a car that is worth S$100,000. However, what you should be looking for is not the maximum loan amount you can get under the permitted LTV ratio, and rather is whether your income level can comfortably handle such loan's repayment schedule.
While you should have a good idea about how much you need to borrow, it might be time for you to reconsider just how much loan you end up getting if you find that monthly repayments for the loan is more than what you can manage. You should never borrow more than you need, and you should never borrow more than you can afford.
|Loan Type||Maximum Loan Limit|
|Home Loan||80% LTV or less depending on type and number of property you own|
|Car Loan||70% LTV|
|Renovation Loans||6x monthly salary|
|Personal Loans||4-6x monthly salary|
|Education Loans||8-10x monthly salary of guarantor|