Personal Loans

Personal Loans Do Require Some Thinking Before We Leap

There are various times where it may be advantageous or desirable to borrow money. While it might seem counter to managing one’s personal finances to purchase something that we don’t have the money to do so, we cannot forget the purpose of our making money and acquiring wealth, and borrowing can indeed be well-aligned with this higher goal in some cases.

There is, of course, always the option to mismanage our finances and borrow too much or for the wrong purposes, but this lack of appropriateness is also measured by how it contributes or takes away from our personal utility or ultimate happiness.

We may also be guided by moral principles, for instance in a situation where it may be to our advantage to not repay money borrowed, if we are elderly and will never need to borrow again for example, and we may still choose to repay it because we feel that’s the right thing to do. This again is a matter of personal utility, as we are choosing the outcome that makes us happier, and the cost of doing so would have been taken into account as the cost of our sticking to our principles.

Personal utility is therefore central to not only decisions surrounding whether we should get a loan or not for something, or use available credit on a revolving loan product such as a line of credit or credit card, it is central to every decision we make in our lives.

We therefore need to strive to at least make this more transparent, as if we are not focused on being happy, we will do a poor job of achieving it. Even though this all should be completely intuitive, using the rational mind that social scientists use in their analysis, many of us are burdened with conflicts that will cause us to decide quite irrationally at times, and this certainly includes spending money we probably should not, for reasons other than to maximize our happiness.

Personal LoansOne of the main ways that we do this with personal loans is to use them to purchase things without properly considering the future, the overall impact that these decisions have upon our lives. Borrowed money will have to be paid back, which involves adding happiness now while reducing its potential later, and we need to account for the whole picture lest we come to regret the loan later.

A good example of this is one living a certain lifestyle during their working years and the being left in squalor upon retirement, where the marginal pain in retirement can far exceed the marginal happiness that this additional spending provided.

This isn’t just about retirement though, as we usually do not have to wait to see the effects of when we overborrow and overspend, and the pain can come as soon as the very first payment is due. While lenders do practice due diligence in seeking to keep us within our capacity to repay personal loans, those who are bent exceeding it will usually find no real obstacle if good judgement does not ultimately backstop this.

Personal Loans Can Also Make a Great Deal of Sense

Controlling one’s borrowing does not mean just seeking to limit it though, even though interest is charged and we will pay more for whatever it is we are spending the money on by getting it now. There are times where the ultimate calculation comes out clearly in our favor no matter how thrifty we may want to be.

Buying a home is one of these instances, and given that we can generally make payments on these loans, including interest costs, for about the same amount of money as it would cost to rent a comparable residence, capturing the wealth of the home increasing in value over the years then becomes a pure benefit.

We can still overdo this though, and we see this all the time with people who purchase a home that is beyond their means, where the size of the loan payments together with everything else they spend their money on can place them in an uncomfortable situation. While the culprit here is usually the other spending, if we set our housing payment too high, we can end up stretching ourselves too thin and struggle to keep up, causing our overall borrowing costs to increase, and even seeing ourselves thrown into insolvency and default if we really mess this up.

It’s certainly better to overspend on a home than it is on other things though. If housing prices double over a certain time, and we buy a home for $250,000, we’ve made that much money over this time by owning it. If we stretch ourselves a little thin and go bigger, with a $500,000 house, what we have given up by needing to cut corners with our personal spending may be well worth it.

This is not to suggest that the goal should be to buy the most expensive home you can qualify for, but we do need to realize that homes are investments as well as places for us to live, and this actually ends up being a sweet deal for us if we can comfortably make the payments. That should be the criteria actually, as it is preferable that we do not become uncomfortable financially, whether that be through not having enough in retirement or not having enough while working,

The equity that we expect to build with our home loan therefore does need to be accounted for, but only alongside everything else. Borrowing to buy a car has the opposite effect, as the more expensive the car, the greater the amount of depreciation. This just means that the cost of ownership is proportional to the cost of the vehicle,

Just about everything else is proportional as well, and since borrowing does come at a cost, we need to make sure the overall cost of the spending is worth it. When we borrow for our education for instance, we assume that the money spent on this will serve as an investment that returns much more than the principal and interest costs of the student loans, where we are clearly better off paying this price to gain more later.

This should at least have us considering the impact of various courses of study on our overall finances throughout our careers, and although this does not necessarily mean that we should always choose what provides the most financial gain, but we should consider this alongside other variables such as interest and aptitude.

Seeking to Understand the Overall Value of a Personal Loan

We think of exceeding our capacity as representing situations where we cannot keep up with our loan payments, leading to default or other resolution that does not having us repay our loans in full and on time. The bar here really needs to be set at not what we can manage with difficulty but what we can manage comfortably, without unduly impacting our lives and our enjoyment of life overall.

If we borrow to buy something that provides 1 unit of happiness, but we have to defer 2 units to get it, that’s not a very good deal, which can and often does happen. If we have to cut down on things when we add in the loan payment, the real cost here is what it costs us to give up these things.

It might even be the case that, even though we may have to give up things that might be seen as exuberances, what we buy may be even more exuberant, and we may end up missing and being made unhappy by losing these higher utility yielding exuberances that we chose to forsake by getting the loan.

It really needs to come down to weighing the benefits of getting something now versus not what the monetary cost is, but instead what we have to give up for it. This can range from anything from not being able to provide things we consider to be important to our lives right now, to not being able to stash this money away when future needs arise.

We often will prefer the present too much for our own good, and managing the future usually requires conscious effort if you are not already wealthy enough to not have to worry about it. Even very wealthy people go broke sometimes though, so having enough money to live comfortably for the rest of your life may not indemnify you if you are not careful and sensible about accounting for the future.

Our cost of borrowing will also influence this, or it at least should. It often is not taken enough into account though, and those who pay the highest rates tend to have the least regard for the future. These higher rates are not only indicative of a history of financial mismanagement, and although that’s not always the case it generally is, they also indicate a much lower threshold of discipline.

When we have to pay more to borrow though, these higher rates should instead restrain us, but if you’re not so worried about how you will pay the loan back, you probably aren’t too worried about this one being more burdensome and difficult than usual.

We Need to Think Enough Before We Leap into a Personal Loan

This is what happens a lot with credit card debt, and credit cards both come with a high interest rate and very little regard to your capacity, as lenders will often increase the borrowing power of their clients to the extent that their collective credit card limit can be used as a tool for financial destruction if they choose. People do choose this quite often in fact.

Once our credit worthiness has hit the skids, this is where we move to the highest interest category, and there are usually people who will lend to you regardless of how deep the hole becomes. You can get a payday loan as long as you can prove you receive income, but the rates on these are extremely high, but even 10% a week doesn’t scare some.

On the other hand, even payday loans can have their time and place and be quite useful actually, if for instance the alternative is to be evicted and see you and your family thrown out on the street. We do need to have a sustainable exit plan though and it does us no real good if that’s going to be the ultimate fate and you are just postponing the inevitable for a little while and also pay dearly for this privilege.

For those who cannot maintain their cash flow, adding large interest payments like 20% of your bi-weekly paycheck can easily serve to increase one’s level of financial disaster. If you make $1000 bi-weekly, and you get a loan for half of that, $500, the next paycheck will only leave you with $400, after paying back the principal amount of $500 plus $100 interest. Being down this $600 will require you to take out another loan with them, and this all usually does not end up in a good place.

Payday loans are only one form of borrowing to make up for a lack of cash flow, and since the repayment of any loan for this purpose will need to come out of this cash flow, unless we fix the problem, we are headed for the same place as the payday loan borrowers usually end up.

Anytime our expenses exceed our income, unless we are confident that our income will go up enough during the life of the loan to make it ultimately manageable, borrowing to overcome the deficit just sets ourselves up for failure. Governments can get away with this but we cannot.

We also need to consider the relative benefits of obtaining something now versus saving up to buy it, and with a lot of things, things that aren’t really big-ticket items that it may take us years to save while being deprived of the benefits of the purchase in the meantime, we can often save up for it instead.

We are going to have to pay for it anyway, and if we cannot afford to save up for something, we cannot afford the payments on it either. If we really need it now, or would substantially benefit from this, enough to make sense of paying more for it to have it now, that can make sense, but we take out loans all the time for things that we should instead be saving for.

Whether to take out a personal loan for a certain purpose should therefore require at least some deliberation. Our rational side should always be in control, lest our irrational side be given the reins and lead us down the wrong road. To avoid this, we both need to keep our eyes on the road and especially on the horizon.

Personal Loans FAQs

  • What is the best place to get a personal loan?
    Your bank is often the best place to get a personal loan, mostly due to your already having a relationship with them, your building up internal credit with them and their valuing you more as a client overall. However, this does not mean that we should not look elsewhere and shop around as we may be able to find better terms with another lender.
  • What banks offer the best personal loans?
    Personal loans are fairly simple and there’s only a few things that we need to look at to find the best one for us. The amount that we may borrow will matter, as well as the rate and the flexibility of repayment terms. Sometimes smaller banks may offer better terms than larger ones and it pays to seek out several sources to compare.
  • What is a good personal loan rate?
    Personal loan rates depend on the quality of your credit history, included but not limited to your credit score. For those with excellent credit, a good rate would be 6-7%, but a good rate for those with less than excellent credit will be higher, or much higher with bad credit. The only way to determine what a good rate for you would be is to shop around.
  • How can I get a personal loan fast?
    The fastest way to get a loan is to already have an arrangement established to borrow money, from a line of credit. Personal loans generally don’t take very long to set up and can often be done on the same day, especially if you apply for one at your bank. What takes the time with personal loans are manual reviews but good applications can be approved very quickly.
  • How are personal loans calculated?
    There are four components to calculating the payment amount for a personal loan, which are the original principal amount, the length of the loan, the number of payments that are scheduled to be made over the period, and the annual interest rate. You then put all these variables into a loan calculator which will figure out what your payments will be.
  • How can I reduce my personal loan EMI?
    There are three ways to reduce your personal loan EMI, which is the amount that you will need to pay over a given period. You can either find a comparable loan that offers a lower rate of interest, reduce the amount borrowed, or extend the loan over a longer period of time, which increases the total interest paid but reduces the payment amount.
  • Do personal loans affect your credit score?
    When you first open a new credit line, this will reduce your credit score a little as it reduces the average amount of time that you’ve had your credit products which is one of the factors of your credit score. However, as you pay down the loan, this will help your score, and ultimately, loans paid as agreed will improve your credit history and score.
  • Is getting a personal loan worth it?
    Whenever we borrow money, it will cost extra in interest so we need to make sure that the use of the principal amount is a wise one and it’s also wise to pay more to get it now versus waiting and saving up for it. Often times people focus on the benefits of a loan too much or are impatient and don’t properly assess the overall value of the loan including total costs.
  • Will paying off credit card debt with a personal loan improve credit score?
    Using a personal loan to pay down or pay off credit card debt will both help your credit score immediately and in the long run provided that the loan payments are made as scheduled. When you get the loan, this will decrease the ratio of revolving debt to available credit if you keep the credit cards, which is one of the reasons why keeping them is a good idea generally.
  • Will applying for a personal loan affect my credit score?
    Any time you apply for credit, this involves a credit check and credit checks in themselves cause your credit score to drop a little, although not by very much. Credit scores are meant to be used though so you don’t ever want to have this concern stop you from applying for credit when there is a good reason. Applying for credit when you don’t need to is not a good idea though.
  • Do personal loans show up on credit report?
    Provided that you are the primary applicant with a personal loan, it will show up in one or more of the credit bureaus. Some lenders just report to one so your loan might just show up there. If you are the secondary applicant, some lenders only report the primary applicant’s activity so this is something you will need to ask if you are looking to build your credit as well.
John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.