Should one opt for a personal loan?

Applying for a personal loan when in need of financing is a favoured option of individuals who want to avoid the relatively expensive interest costs of credit cards and other debt options. Also, with a personal loan, you can spread out the payments of the loan over a predetermined period to fit your budget.

Most banks and other financial institutions have developed suitably flexible loan packages that can be structured to fit your specific needs. Usually a personal loan of between R1 000 and R15 000 is granted over a period of a couple of months to about five years. Most banks insist that 1/40th of the loan amount is paid off every month. Interest rates can usually be negotiated and the rate you pay will usually move up and down in accordance with the bank rate.

Most people use personal loans to finance home improvements, education needs, computers or travelling costs. Buying household goods (furniture etc.) through personal loans are also popular because of the relatively high interest rates of in-store credit facilities. These are generally acceptable ways to utilise personal loans and, with prudent budgeting and a suitable loan package, a personal loan should not be a burden to you. But a personal loan could also turn out to be an enormous millstone around your neck when used to finance the wrong financial needs. There are some specific ‘inappropriate' uses for personal loans:

- Investments. Borrowing at a higher interest rate than the rate of return on an investment is never a good option. Not only will your profit on an investment be significantly watered down by the interest you have to pay on the loan, but if your investment is at all risky you could stand to lose a lot of money.

- Paying off debt. Banks and financial advisors generally frown on using a personal loan to pay back debt. Even if the interest rate you will pay on your personal loan is lower than what you would have paid on the outstanding debt, you could end up in a debt spiral. In many cases, the individual merely starts accumulating debt again and soon ends up in a worse position than before.

- Purchasing consumable goods. In general, borrowing to purchase consumable goods should be avoided.

If there is a repayment structure, ensure that the repayment term is less than the useful life of the asset purchased. Travel is perhaps the one exception, unless you consider the memories/experience gained as an asset. Speak to your bank manager or a financial advisor if you are still uncertain on whether you should use a personal loan to finance a specific need. Possibly an extended overdraft or another type of credit facility could alternatively be utilised.

What to look out for in a personal loan

It is crucial to carefully consider your own financial position before approaching financial institutions for a personal loan. How much will you be able to pay back monthly? Will you have a steady income for the next few years to pay back the required amount? Do you need a fixed amount - or is there a possibility that you will want to access more funds later? When you have decided on the features and terms of a personal loan that would suit you best, you can start shopping around to match a loan product to your specific needs.

When making a choice on a loan product you first have to decide if you need a fixed or revolving loan facility. A fixed loan is a one-off advance with monthly repayments over a predetermined term. The payment term could stretch over a couple of months to about five years and applicants can usually borrow between R1000 and R50 000. A revolving loan (also called ‘open end credit') is a more flexible financing option and is specifically suited to people who will possibly need access to additional funds later. A revolving loan allows you - after a percentage (usually 25%) of the original loan has been repaid - to extend the loan to its original limit. Unlike with a fixed loan you can therefore have access to supplementary funds as you need it without reapplying for another. With a revolving loan you only pay interest on the amount you use. The loan does not have a fixed term. One drawback of a revolving loan is that it could tempt some bank customers to overextend themselves. Avoid this by reviewing your use of the loan facility continually. Revolving loan facilities are usually afforded to customers in good standing with their banks. If you have a clear credit record, a stable income and a low debt level, you could try to arrange a revolving credit facility with your bank.

Always negotiate the terms of a personal loan with the lending institution. You will be in a better position to do this with the bank with which you have most of your accounts. Always insist to finance only the exact amount you need. If you need R4 200, but your bank only want to lend you a round figure of R5 000, it means that you will be paying interest on R800 that you strictly speaking do not need. Before applying for a loan make sure that you know exactly how much your planned expense will cost. Most personal loan products give the consumer a choice between a fixed or variable interest rate. A fixed interest rate means that your predetermined monthly instalments will stay the same throughout the repayment term. A variable rate will change as the prime rate changes. Make certain that your loan product has the suitable interest rate arrangement to suit your financial position and management style. You could prefer to pay a fixed amount over a specific term because it will make your budgeting easier and will protect you against unexpected hikes in your instalments. If you think that interest rates are on a downward curve, you could bet on a variable interest rate. However, it is very important to make sure that you can afford higher instalments in case of a rate increase. The interest rates on personal loans are usually close to or at the Usury Act Minimum rate. Some banks offer an insurance package with a loan. The insurance will cover some dread diseases and the death of the borrower. Most packages will ensure that in case of death or calamity, the loan is repaid and that it won't be an additional financial burden on the person's dependants.

Will you qualify for a personal loan?

When applying for a personal loan the lender will examine your current financial situation as well as your credit history before approving your application. This is necessary to prevent an applicant from taking on too much debt and defaulting on his or her financial obligations. A thorough scrutiny of a potential borrower's financial status will also reduce the risk of a defaulting loan which can damage the lender's own financial health. Financial institutions will generally examine three aspects of your financial situation when deciding if you should be granted a loan. 

- Credit History. The bank or financial institution will ask a credit bureau to investigate your credit record. If you have defaulted on the repayments of credit related products in the past or did not pay your accounts timely, it will show up in the credit report. If you do not have a clear credit history your chances to get a loan is smaller, but not diminished. If the lender do decide to extend a loan, a blemished credit record will, however, have an influence on the amount that you will be able to borrow as well as the interest rate on the loan. If you are applying for a loan from your own bank, your transacting record with the bank will also be looked at. If you have a history of overdrawn accounts etc. this will have an effect on your application. 

- Affordability. The lender will also evaluate your ability to afford the repayments of a loan. Most banks have developed frameworks with which they can measure how much you will be able to repay. Loan applicants are often eager to get the loan, and many overestimate their ability to afford the monthly repayment. The lender will compare the income and expenditure details provided by the applicant against various norms built up over years of experience to measure the applicant's ability to afford the loan. Your other lending liabilities (mortgages, vehicle loans etc.) will also form part of the affordability calculations.

- Security. If your lending requirement is above a certain level you may need to offer security. This could mean that your house or any other assets could be offered as collateral for the loan. Should you default on the loan the lender can repossess these assets. The criteria for fixed personal loans and revolving loans differ. Because a revolving loan gives the lender access to more credit it is more difficult to qualify. Most banks will insist that you have cheque or savings accounts with them and that you also earn above a certain limit to qualify for a revolving loan.