Excessive borrowing can lead to financial trouble.
Consumers need to ensure that loans taken are well within their means. Here are eight things to consider when taking out a loan.
- A need or want?Before taking a loan, ask yourself if the item or service is meant to satisfy a need or a want.If it is a “want” – not necessary and just for consumption – perhaps it would be better to save for it rather than to pay a “premium” price (that is, the interest cost of borrowing). For instance, don’t borrow to pay for a vacation or a new kitchen appliance or get a new air-conditioningTake time to consider if there is an alternative to borrowing now or borrow a smaller amount instead. Better still, don’t buy it at all if it is unnecessary.
However, if the purchase is for investment purposes, then perhaps it is okay to get a loan. This could b for renovations that add value to your home, or enhancing your future income earning ability via training and education or for business.
- Interest cost of borrowingConsumers should be aware of the type of interest rate that is stated in the loan agreement or marking material.And when considering loan options, compare like with like.Some loans use the annual percentage rate (APR), which reflects the actual interest cost of borrowing, while others refer to the simple interest rate.
The simple interest rate is calculated by applying a flat rate on the original principal amount for the entire loan tenure.
The APR is interest calculated based on the declining principal balance over the tenure of the loan.
As the borrower makes monthly repayments, the principal is reduced every month, so the interest payable on the principal also reduces each month.
Make sure you pay off the debt before the interest starts to build-up. If you miss a payment, you may be automatically bumped up to the highest annual interest rate.
- Current debt service ratioBefore taking the loan, calculate your debt service ratio. It is the percentage of your monthly income needed to service long-term liabilities.It provides a useful guide to how much of your take-home pay – that is gross pay less 20 per cent employee CPF contribution and personal income taxes – is used to pay debts.Debt payments are monthly expenses like mortgage, car loans, personal loans or even credit card debts. A healthy debt servicing ratio – debt dvided by income – should be 35 per cent or less.
To put it another way, out of very $1,000 of after-tax and CPF income, you should spend $350 or less on debt repayments.
If the consumer already has a high amount of outstanding debt to service, it is best to pay down existing debt first before incurring more.
And even if your debt service ratio is less than 35 per cent, it is prudent to consider if you have surplus funds to take on another loan repayment after paying monthly living expenses.
Make sure you know your cash inflow and outflow before taking on another loan.
- Loan tenureIt is worth considering the optimal loan tenure as it affects monthly repayments and interest paid.Generally a longer loan tenure means smaller monthly repayments but a shorter loan tenure may lead to lower interest paid.So to minimise the interest payable, a shorter loan tenure may be an option, but the repayment will be higher.
Some financial experts suggest you make the highest repayments you can manage so that you clear the debt in the shortest possible time.
When deciding on a loan tenure, consider your monthly commitments and take the appropriate loan tenure based on your monthly cash flow.
- Early payment optionsNot all loans allow customers to settle early, so read and understand the terms and conditions of the loan before signing up.An early settlement fee is usually imposed if a loan is paid off early.If you redeem your personal loan before the full term expires, an early redemption fee of 3 to 5 per cent of the outstanding amount at the time will apply.
Home loan customers are urged to look beyond interest rates and consider factors such as the lock-in period and penalty fees.
Another potential cost is the loan cancellation fee.
- Late payment feesMost loans stipulate late payment fees. These are over and above the interest charged for late payment, so go through the terms and conditions of loan agreements thoroughly to ensure you understand them clearlyPay special attention to fees incurred for late payment.So keep track of the payment dates and remember to pay before the due date. Try to have a fewer loans or credit facilities and avoid having multiple sources of credit.
In order not to incur interest and penalty fees, pay your outstanding credit in full.
- Payment flexibilityAvoid defaulting on loan repayments as it will hurt your credit history. However, a typical loan tenure is for at last 6 months, and sometimes it is hard to predict what will happen so far into the future.You might hit cash flow difficulties at some point, so it is worth looking for loans that offer some payment flexibility and provide rewards for prompt payment.For those who can’t meet their monthly payments, they approach their lender first for assistance to restructure a loan. Quick Credit will usually review such requests on a case by case basis. A responsible lender will work with its customers to provide a solution.
- Other loan terms and conditionsMake sure you understand the key fees and charges stipulated by a loan agreement. This makes you aware of what to expect when a loan is taken and reduces any surprises after it has commenced.If you are acting as a guarantor for a loan, be clear about the terms and conditions of the agreement, especially those related to your obligations as a guarantor.In the eyes of the creditor, the guarantor is the “same” as the borrower, meaning, both the borrower and the guarantor are jointly and severely liable for the loan.
This means that even if you are willing to act as a guarantor, you should also consider your own ability to make repayments in case the principal borrower fails to repay.