Personal loans are used to purchase new cars, fund holidays, update and improve your home, and even consolidate debts.  There are different types of personal loans.  The two main types are:

Secured Loans – A secured loan has some asset held as collateral against payment.  A car loan is an example of a secured loan.  If you don’t pay your car note, the lender has the right to confiscate your ride.

Unsecured Loans – An unsecured loan has no collateral set against it.  A credit card is an example of an unsecured loan.  Unsecured debt is usually higher in interest and fees than secured debt because if you don’t pay, it isn’t as easy for the company to recover the loan costs simply by confiscating some asset.

When it comes to taking out a personal loan, FIDO suggests that you distinguish between wants and needs.  By distinguishing these two areas, you can often save yourself hundreds or even thousands of dollars of interest by simply saving up for those items you want.  For example, if you want to take a trip that costs $1,000, at a 12% interest rate, you will pay about $135 in interest if it takes you 2 years to pay the loan back.  If, instead, you save up for the trip, you can place that $135 you would have paid in interest in savings account.

Once you have determined whether you are faced with a “want” or a “need,” then you can decide whether a loan is necessary or if you can simply save up for the item.  If you determine that you must take out a loan, then it is time to do your homework.

Determining how much loan you can afford

The very first step in obtaining a loan isn’t to go out, find that car you like, and have it financed.  Instead, if you do a little research and go into the office knowing what you can and cannot afford to pay each month, then you will save yourself potential heartache later.  Just because the car dealership allows you to finance a $25,000 vehicle doesn’t mean you can afford it.

The first step in determining what you can afford is to track your expenses – especially your fixed expenses for at least a month.  By doing this, you can see spending patterns and you know how much money you have each month to dedicate towards loan repayment.  FIDO has a wonderful budget calculator to help you visualize your income vs. your expenses.

Using Finance Calculators Online

Your next step in securing a personal loan will be to utilize one of the many finance calculator tools available online.  Infochoice is a great resource for this.  You will get a list that allows you to compare rates – and in some cases, you can apply online.

When looking at the loan comparison, you may wonder what all the different numbers mean.  For example, you may see a chart that looks something like this for a $10,000 loan:

The initial two interest columns are the current variable rate.  If you choose a variable rate, you could wind up saving money on interest – if the interest rates go down.  If the interest rates go up, however, you could spend more money on interest than otherwise.  The comparison rate is the interest rate with all fees taken into account. According to the Personal Loans website, the comparison rate is mandated by the ASIC (Australian Securities and Investments Commission).  This rate includes both the interest rate and the fees and charges except:

• Any government fees or charges
• Charges applied in special circumstances
• Any perks to the loan

For more information on comparison rates, you’ll want to view the two available factsheets: Comparison Rates – A Consumer Guide and Comparison Rates: Frequently Asked Questions.

The next four columns in the above chart refer to a fixed-rate loan.  You’ll notice that while the “Greg Fixed” loan only has an interest rate of 13.89%, its comparison rate brings it up to being about 21.71%.  This means, for $10,000 of borrowed money, you would pay back a total of $12,416.41.  Make sure when you calculate the estimated monthly payments, you use the comparison rate, not the initial interest rate for a more accurate estimate of what you will need in your budget.

Fees

In addition to interest, various fees may be charged to a loan.  These fees include:

• Establishment Fee – the fee charged for starting up the loan.  It is often added to the amount being borrowed.
• Ongoing Fees – monthly charges for continuing the loan
• Exit Fees – watch out for exit fees.  If you pay off your loan early you may be required to pay a fee.
• Redraw Fees – if you are ahead on your repayment schedule, sometimes you can take out funds that were already paid into the loan.

Remember: While it might seem like a lot of work doing all the homework and comparison shopping ahead of time, it will save you hundreds (possibly thousands) of dollars – and your sanity.  By carefully planning for a personal loan that you must take out to meet a need, you can avoid falling into a potential debt-trap.