A practical guide to responsible borrowing

Most of us experience money stress at some point in our lives. Often this can occur through increased rent, unexpected medical bills, car repairs, or excessive expenses.

In such cases, taking out a personal loan can be a good short-term option. Especially if we don’t have enough savings or enough cash flow to cover this extra expense.

But while they can be helpful in some cases, they also carry risks that you may not be aware of. It is therefore important to practice responsible borrowing.

To do this, you need to know how personal loans work, how much they actually cost, and the consequences of not being able to pay them back. This guide will help you improve your understanding.

What is a personal loan?

A personal loan is money you borrow from a lender and pay back in regular repayments, with interest, over an agreed period of time. Most personal loans in Australia are unsecured personal loans. This means you don’t need to offer your home or car as collateral. Instead, the lender relies on your income, credit history, and ability to repay as determining factors of whether they will give you a loan.

Some lenders also offer personal loans for bad credit. This is for people who have had repayment problems in the past or have scars on their credit file. These types of loans often come with higher interest rates and stricter borrowing conditions.

Typically repayments are made weekly, bi-weekly or monthly. They also usually include both interest and a portion of the original loan amount.

Why do people take out personal loans?

People choose to take out a personal loan for a variety of reasons. Some of the most common are:

• Consolidate your debts

• Renovate your homes

• Finance a wedding, vacation or new car purchase

• Unexpected emergencies (like medical bills and repairs)

They can be seen as an especially attractive proposition for those who want the certainty of fixed rates and predictable payments. It also provides faster access to cash compared to savings held in term deposits and ensures they do not run out.

Understanding interest rates

Interest rates are always in the news, mainly because The RBA meets eight times a year to set them. They’re often the first thing people notice when comparing personal loan options (the current cash rate at the time of writing is 3.6%). But these are only part of the picture.

The true cost of a loan includes interest accrued over time. It also covers fees charged by the lender, including setup fees, monthly account fees, and late payment penalties.

Therefore, the total cost of a loan may be much higher than expected. Especially when repayments are spread over several years. So borrowing responsibly means looking beyond what’s affordable today. It should also consider how repayments will affect your finances in the long run.

Fixed and variable interest rates

Lenders basically offer two types of interest rates: Fixed or variable. This allows borrowers to choose between predictable payments and flexibility.

The main difference between the two is that the fixed interest rate remains the same for the entire life of the loan. This makes repayments predictable and can help people budget with more confidence. In contrast, a variable interest rate can change over time. If interest rates rise later, repayments may increase. However, if the rate falls, they may also fall.

Both options have advantages, but also involve trade-offs. For example, fixed rates provide stability but less flexibility. Variable rates, on the other hand, may start lower but may carry uncertainty.

What does responsible borrowing really mean?

The concept of responsible borrowing revolves around understanding and respecting your financial limits. Essentially, this means borrowing only as much as you can repay within the agreed time frame. This also means being realistic about how repayments will affect your daily life.

In addition, responsible borrowing requires not only understanding the consequences of missed payments, but also realizing that borrowing money may actually create more problems than it solves.

What happens if you miss repayments?

If you miss repayments on your personal loan, you face immediate consequences. These often include reminder notices, late fees, and negative credit scores. The latter of these may affect your ability to borrow money in the future.

If you continue to miss repayments and fall into debt, you may face escalating actions. These may include receiving formal notices of default, potential repossession of your assets (for secured loans), and aggressive debt collection actions. You may even face legal action or your lender may sell your debt to a third party.

If you are having any problems making your loan repayments, it is vital that you contact your lender. They often have measures such as difficulty options that can prevent default listings and credit score penalties.

How can you evaluate whether you can afford a personal loan?

Before taking out a personal loan, you should take the time to fully evaluate whether you can afford it. Just because a lender is willing to give you an advance based on minimum criteria doesn’t mean you can manage the repayments. Only you can decide how much taking out a loan will affect your daily life and overall financial situation. This is especially true for young people who still owe HECS debt from university.

For example, if you have no money left for emergencies or basic living expenses after making repayments, this may not be a wise move.

What common mistakes do people make when taking out a personal loan?

Unfortunately, many people have trouble getting a personal loan because they assume that being approved for a loan means they can afford it. However, borrowing the maximum amount offered could quickly put a huge financial burden on them. This is especially true when their income changes or their cost of living increases.

Most of the time, people apply for a loan in a hurry due to their circumstances. This can lead them to make poor decisions by ignoring the total cost of the loan and end up paying much more than they expected over time.

Additionally, some borrowers run into trouble by taking out more than one personal loan. Or, take one out without really understanding the terms and potential consequences of doing so.