Is a Personal Loan Better?

Personal loans are attractive to many borrowers because they are generally quick and easy to obtain

Banks continually attempt to entice people to borrow at attractive rates and can usually settle a deal within a couple of days.

When it comes to buying a car for instance this is a very attractive option because speed is usually the essence. In order to get the best deal from the car dealer you sometimes need to act quickly and that's why it's easy to fall into the trap of signing up for a personal loan on the spot.

With personal loans becoming more attractive and easy to obtain however, many borrowers act without thinking and end up with several personal loans for various amounts and this can really constrain cash flow quite severely.

How the problems stack up

For example, buying a new car for $30,000 with a personal loan at 11% interest over a seven-year term would require repayments of $509 every month. Similarly, a further personal loan for $14,000 over five years at 11.2% would cost $302.96 a month. Although each personal loan may have looked affordable in its own right it's easy to see how debt can accumulate and make life a little more uncomfortable. In this case, borrowing $44,000 is costing just over $810 a month.

Think of it this way, if you had a home loan over 30 years at 7% interest and were paying $810 a month, it will be sufficient to borrow $122,460!

This dramatic comparison does not mean that personal loans are better or worse than home loans, it simply means they are different because they are calculated at different rates of interest over different periods of time.

When is a personal loan a good alternative? A personal loan can be a good choice where:

Most lenders will be happy to refinance a home loan up to a maximum of 90% of its market value. Remember, if you borrow more than 80% of your house's value you will have to pay lenders mortgage insurance.

The market value for a home is determined by a valuer appointed by the bank and is quite likely to be lower than your expectations. This is something which catches many borrowers unawares but there is no point complaining to a bank because of a low valuation as they are very unlikely to change their mind or request another valuation.

If you refinance your home loan to a new lender and wish to consolidate some of your smaller existing debts, you should be aware that some lenders have limitations on how many debts they are prepared to incorporate into the new loan.

When you are transferring your home loan to a new lender you will need to provide six months home loan statements to prove you are making your repayments on time. As well, you will also need to supply up to 6 months statements for any loans you wish to consolidate. This gives the new bank a chance to look at your loan history and to judge whether or not you are a good risk.

You will have to pay for the valuation on your house as part of the loan application fee, and this will not be refundable even if you do not get a favourable value and decide to withdraw your application.

Now that you are aware of the conditions under which the bank will allow you to use your remaining equity, it's time to look at whether it's really worth it or not.

Previously, we looked at an example of a couple who owned a house with a value of $500,000 and an existing home loan of $250,000. They were able to incorporate a personal loan and some credit cards and roll their total debt into one loan of $268,000 and save themselves several hundred dollars a month.

This is a good example of how using equity can ease the cash flow and make life financially more comfortable. Nevertheless, there are a few things to consider.

You need access to some quick cash and can easily afford the monthly repayments.

The cost of consolidating your home loan outweighs the cost of a personal loan.

You only need the money for a short term and you have sufficient income to pay the loan off quickly.

But, every home owner should always give consideration to using their home equity to fund any necessary purchases that might otherwise require a personal loan. This is because the interest rate is generally much lower and if you manage your repayments carefully you can actually save money.

Here's how you can use a home loan to pay off a personal loan quickly and save money at the same time.

Get a quote on a personal loan and note down the required monthly repayments.

Work out how much the personal loan will cost you if you pay the minimum monthly repayments over the full term. In other words multiply the monthly repayment by the number of months on the loan term.

Work out how long it will take you to pay off the same amount of money in a home loan at the lower rate of interest by using the same repayment you would have made in the personal loan.

The resulting calculation will tell you whether it is worthwhile using your home equity to fund your new purchase or whether a personal loan is more suitable.

Here’s an example.

Say you want to borrow $20,000 for a new car and a personal loan over seven years at an interest rate of 12% would require you to make monthly repayments off $349.56. Over the full seven years you would make total repayments off $29,362.96.

Compare this against a home loan of $20,000 over a 30 year term at 7.5% requiring a monthly repayment of $138.97.

Now, work out how much time it would take to pay out a home loan of $20,000 if you made monthly repayments of $349.56. The answer is 70 months.

This example shows that you would pay a total of $24,497.90, making the home loan $4865.06 cheaper than a personal loan.

In cases such as this it is easy to see that using equity can be a much cheaper alternative to a personal loan, but it may not always be the case. Remember you have to commit yourself to making the same repayments into your home loan that you would have made in a personal loan.

This is the only way that using a home loan can be to your advantage. If you are not prepared or you are unable to make the same repayment, then you need to re-evaluate your position and make a different decision.

Performing these calculations can be a little tedious but the savings can be quite substantial. There are plenty of online calculators that can assist you in making these comparisons and the time you spend doing so will be well worth the effort.

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