When you need a personal loan, time is of the essence. Whatever the reason, the temptation is there to grab the first loan offer you get.
But to avoid getting stuck in a bad financial situation, it’s important to take a beat and do some research. The first step is to understand all of the terms that are associated with the loan document.
Stick with us for an easy-to-read primer on all the financial terms you need to know before signing on the dotted line.
Interest rates: Fixed or Variable
Let’s start out with something basic. All loans carry interest charges – this is how the lender makes money on the transaction. The better your credit score and the higher your income, the lower the interest rate on your loan is likely to be. But there are two types of interest, fixed and variable.
A fixed interest rate is best if you need to budget carefully and can’t tolerate fluctuations in your monthly repayment amount. The percentage of interest charged won’t change for the life of your loan with a fixed rate. Where this can be negative is if the market rates go down. In that case, you’ll be paying higher than average interest on your loan.
A variable rate, on the other hand, is tied to the market and changes as the economy does. Choosing a variable rate is always a gamble. If the market improves, your payments will go down and you’ll save money. But if interest rates go up, so will your payments.
Loan types: Secured or Unsecured
Different types of loans present varying levels of risk for the lender. A secured loan is one in which the lender requires you to put up some form of collateral that it can claim if you default on your loan.
Therefore, you will need to offer something of value that’s worth at least as much as the loan amount. If you stop making payments, your lender will claim your collateral and sell it to recoup their investment.
When you get an unsecured loan, you don’t have to put up collateral. However, your lender still needs to ensure that they will profit from the arrangement, so interest rates are generally higher. And, the lack of collateral does not mean that the lender can’t sue you if you default.
As an added layer of protection for the lender, it’s more likely that you will be asked to provide a guarantor or co-signer with an unsecured loan. Read on to learn more.
Loan guarantor
When a loan applicant has less than stellar credit or no credit history at all, the lender will usually ask for a loan guarantor. That person will be liable for the balance of the loan if you default at any point. This is a risky situation for the guarantor, so make sure that you are confident in your ability to repay the loan before asking someone you love to step in. Relationships can and have been destroyed this way.
However, almost everyone will need a loan guarantor at some point. It’s almost a pre-requisite for borrowers on their first loan. Having a guarantor also means that their good credit score can lower your interest rate.
Loan term
All loans are issued with a pre-determined length of time for you to pay it back in full. That’s called the loan term. Each month, you pay an amount that includes some principal (the original loan amount) and some interest. Common loan terms are 12, 24, 36, 48, or 60 months.
A good way to minimize the amount of interest that you ultimately pay is to choose a loan with the shortest term you can meet. Short term loans often have lower interest rates. Longer term loans offer lower monthly payments, but a higher cost overall because you’ll pay more interest.
It’s also good to choose the shortest term you can afford because having open loans on your credit report makes it harder to receive additional financing for other major purchases. Plan to have all personal loans closed when you apply for a home mortgage, for example.
Early exit fee
Another thing to consider before taking a personal loan is whether or not the lender assesses an early exit fee. This fee is charged in some cases if you repay your loan early.
Say you get a surprise windfall and want to use it to close your loan and save some money on interest – your lender may object to missing out on the profit they were expecting.
Because life is unpredictable, it’s always best for the borrower to retain as much flexibility as possible in their loan agreements. If you can avoid an early exit fee, do it. However, the trade-off might be taking a loan with a variable interest rate.
Loan use
As consumers, we tend to think that our spending is our business. But some personal loans are tied to a specific purchase, known as the loan use. Even if you don’t choose a loan that’s designed for only one thing, like health care or home improvement, chances are high that the lender will ask why you need the money.
Lenders use this information to determine your interest rate and other parameters of the loan. As long as you make timely payments for the full loan term, you might not get caught if you use the money for something other than the reported purpose. But if you do get caught, you will be liable for fraud charges and may be asked to immediately pay the loan back in full.
Comparison rate
The comparison rate is a helpful tool for comparing different loans. Because interest rates vary and other finance charges can apply, it’s difficult to know which loans are truly the most competitive. A comparison rate is one number that relates the total cost of each loan including interest and fees.
This number takes into account the interest rate and fee for late or missed payments, as well as any applicable monthly service fee or application fee. By evaluating the comparison rate of various loans, you can determine how much money each will cost you in real dollars.
The good news is that Australia is careful about irresponsible lending, so if you’re not financially prepared for the loan, you probably won’t get it in the first place. That may sound like bad news if you’re in need of some quick cash, but it’s better in the long run for your credit and your financial position.
In any case, make sure you understand the financial terms surrounding your loan. That way you’ll know for sure that you’re getting the best possible deal.
Sources:
https://moneysmart.gov.au/loans/personal-loans
https://www.thebalance.com/know-about-personal-loans-960025#repayment-periods
https://www.whistleout.com.au/MobilePhones/Faqs/how-do-early-termination-fees-work
https://www.finder.com.au/personal-loans/variable-rate
https://www.canstar.com.au/personal-loans/personal-loans-secured-or-unsecured/
https://moneysmart.gov.au/loans/going-guarantor-on-a-loan
https://www.savvy.com.au/blog/top-3-things-australians-use-a-personal-loan-for
https://www.finder.com.au/home-loan-comparison-rates
