Five golden rules when taking out a personal loan

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Borrowing for a high-risk investment like cryptocurrency must be consistent with your risk tolerance and ability to pay the debt in the event of a market downturn.

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Borrowing for a high-risk investment like cryptocurrency must be consistent with your risk tolerance and ability to pay the debt in the event of a market downturn.

Katrina Shanks is Managing Director of Financial Advice New Zealand.

OPINION: Most of us have had personal loans at some point in our lives — be they auto loans, mortgages, or home improvement loans, to name a few.

These loans were most likely a mix of nice-to-haves and must-have purchases.

There are three types of debt – good, okay, and bad. Let’s take a look at each of them.

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Investment debt is good because it aims to help you build your wealth for a secure future.

However, investment debt must be carefully considered. For example, borrowing for a high-risk investment like cryptocurrency needs to be adjusted to your risk tolerance and ability to pay off the debt when the market crashes, as we’ve seen over the past few months.

Katrina Shanks says the most dangerous debt is so-called <a class=payday loans.” style=”width:100%;display:inline-block”/>

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Katrina Shanks says the most dangerous debt is so-called payday loans.

Mortgages are okay because they serve a purpose and are usually something that is likely to give you a return over time.

Personal loans are generally bad debts, although there are exceptions.

These exceptions include when you take out a loan, for example to consolidate your loans or credit card debt into one loan, often at a lower interest rate. Or even buying a vehicle to take you to your place of work, giving you a source of income.

Until the arrival of Covid-19, personal loans were relatively easy to get. Just prove your ability to repay the loan by showing your pay slip and you’re off.

But that has now changed as rising interest rates and reduced risk appetite by major lenders have combined with a general lack of basic financial literacy and good financial behavior by many people to make it a bigger problem.

One of the most common debts is a mortgage. About 1.1 million people have them with a combined value of $34 billion.

The most dangerous debts are so-called payday loans.

This is a really expensive short-term loan that you have to repay within a set period of time. If you don’t, the high interest rate increases significantly to the point where you could end up paying four or five times the original amount.

I’ve seen some with an interest rate of 0.8% per day and when you add management fees it can make for very expensive borrowing. At this rate, it’s the highest borrowing cost you can have.

For example, the total repayment for two weeks for $500 can quickly become $541, or $1091 for a $1000 loan. In addition, there is often an incorporation fee of up to 300 US dollars. And there are additional costs if you default on your loan. Doing this can add $30 a week to the total.

Because you’re borrowing money you can’t afford to spend, you’re immediately at a disadvantage.

If you can pay it back within a few weeks, that’s fine, but sometimes it’s easier to get on the treadmill than off it, and once you’re on it it’s tempting to stay there and get more .

Some golden rules:

  • Ideally, only borrow when you know you can pay it back in time.
  • Have a financial plan so you know what big expenses you’re going to have, whether it’s replacing a washing machine or a new car.
  • Try saving for what you need and want instead of borrowing.
  • Have an emergency fund in case something unexpected goes wrong so you don’t have to borrow money and get into debt.
  • Note that your loan application may appear on your credit report, which means other lenders will see that you need funds.
  • Only take out a payday loan if you have no other options – use it as a last resort. There are alternatives and you should consider them before applying for one. These include From Work and Income (if you’re on welfare), The Good Shepherd and The Salvation Army (as long as you’re on limited income), and BNZ (special rates for students, trainees, and graduates).
Have an emergency fund in case something unexpected goes wrong so you don't have to borrow money and get into debt.

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Have an emergency fund in case something unexpected goes wrong so you don’t have to borrow money and get into debt.

I’ve had personal loans in my life – I had a mortgage and a line of credit for a major purchase when I was younger and on a budget but needed to buy things like a bed, lawn mower and TV.

My rule was to only borrow for the bare minimum and save for the nice.

As my financial advisor would say, a personal loan should be a last resort, and saving for something is far better than borrowing.

There is no risk if you have to wait a few weeks or months to get the money you need together.

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