If you need immediate cash for buying a big ticket item like furniture for your home or if you are falling short of a few thousand dollars for that long-planned holiday, a personal loan can provide the perfect solution. However, you should be careful when using this financial product.
A personal loan that is taken on an impulse and without thinking about how exactly it will be repaid could be counterproductive. You could tarnish your credit score and even risk the possibility of having future loan applications rejected.
These loans are available from a wide range of banks and other lenders. Before finalising a loan, spend a few minutes in understanding how a personal loan actually works. Here are some ways in which you can ensure that you derive the greatest benefits from your personal loan while protecting yourself from the drawbacks that this product can carry.
Home buyers beware
If like the majority of Singaporeans, you plan to finance your home by borrowing from a bank, a personal loan can drastically reduce your ability to get the best home loan possible with the lowest interest rate. Why should your personal loan have an impact on your home loan limit?
This is because the Monetary Authority of Singapore (MAS) has imposed a limit called Total Debt Servicing Ratio (TDSR) rules to ensure that home buyers borrow within their means. According to these rules, the total monthly repayments that you make for all your borrowings, including your car loan, credit card dues, and personal loans cannot exceed 60% of your income.
Let us consider the impact a personal loan can have on your home loan eligibility with an example. If you are planning to take a 30-year home loan of S$500,000 at an interest rate of 2.18% per year, your monthly instalment will be S$1,893.43. If you are making S$3,156 a month, this is already 60% of your monthly salary.
Now, if prior to your home loan application you had taken a personal loan of S$10,000 for a five-year period at an effective interest rate (EIR) of 15.07%, your monthly instalment on this loan would have been S$233.25, which is about 7% of your monthly salary. The problem is that this means you are not able to get the S$500,000 of home you need to purchase your home since your TDSR is now 67%.
It also means that you would have to get a different home loan whose monthly installment has to be S$1,660.18 (S$1,893 minus S$233.25). Assuming the same 2.18% of interest rate, your home loan eligibility would have been reduced from S$500,000 to S$438,405, a reduction of S$61,595.
Personal loans can carry high rates of interest
Although personal loans are easily available, carry a minimum of documentation, and are extremely convenient to get, they can also prove to be expensive. average effective interest rates for personal loans is around 13-15%, though you can sometimes get a bargain as banks often run promotional schemes to attract borrowers.
Borrowers are often attracted to the seemingly low rates that a personal loan carries. For example, consider DBS Bank’s personal loan. It has an Applied Interest Rate (AIR) of 7.99%. However, this “flat rate” of interest is equal to an Effective Interest Rate (EIR) that could be as high as 19.7%.
The following chart illustrates the sharp difference between AIR and EIR.
|Tenure in months||AIR||Processing fee||EIR||Monthly instalment for loan of S$5,000|
The EIR takes into account the effect of processing fees as well as the effect of flat interest rate on the initial loan amount as opposed to the declining principal as you repay portion of your loan every month. Therefore, you should always remember to compare personal loans in terms of the EIR that lenders offer their personal loans at, rather than their respective AIRs. You can read more about how effective interest rate differs from annual interest rate in our guide at the link.
How will you repay your personal loan?
It is easy to get carried away when taking a personal loan. Banks are keen to lend as they earn substantial amounts from this product. The maximum limit is usually based on your monthly salary. For instance, OCBC Bank has an upper personal loan limit of six times your monthly salary. UOB also has a similar limit. In the case of DBS, the limit can be stretched to 10 times your monthly salary under certain conditions.
The problem is that borrowers often overestimate their repayment capacity. If you are unable to repay on time, you could be subject to late fees and penalties. The final cost of the personal loan could be much greater than you had anticipated. It is advisable to prepare a projected budget before you take a personal loan. Calculate whether you can afford the repayments. If you don’t pay on time, the bank could report the delay to the credit bureau and this could affect your credit score adversely.
Borrow only when absolutely necessary
It is very simple to get a personal loan application approved. Unlike other loans, you do not have to specify the reason for which you are borrowing. Consequently, some borrowers use these funds for investing in the stock market in the hope of making a quick return. Others borrow to finance their extravagant lifestyle.
You should never fall into this trap. It is quite justified to use the money from a personal loan to pay off other high-cost debt. However, if you use the borrowed funds for unnecessary expenditure and you cannot repay the loan, you could be heading for trouble.
A useful financial product if used well
A personal loan carries many positive features. You can borrow for a fixed term at a pre-determined interest rate. You have the advantage of knowing exactly how much needs to be repaid every month and when your loan balance will come down to zero. This is quite unlike rolling over your credit card balance where your interest burden increases constantly.
Above all, a personal loan requires you to plan your borrowing in advance. This usually gives you the time to consider whether you really need the funds and the cost that you will have to bear. However, you should remember that a personal loan is one of the most expensive forms of borrowing available and should be used only when there is no other cheaper option.