So, cashflow is tight and you are contemplating getting a personal loan to tide you over. Be it for big-ticket items like a holiday, a wedding, or financial emergencies… as the saying goes, money makes the world go round. What are a few things you should know before taking up a personal loan?
1. The Difference Between a Revolving Loan and a Term Loan
Why do some loans come with an option for a 1, 3, 5 or 7 year term, and fixed installment payments, whereas some don’t? These are 2 different types of personal loans – one is a term loan, whereas the other is a revolving loan.
A term loan is taken for a specified ‘term’ (e.g. 3 years, or 5 years) for which you need to pay regular, fixed installments over the period of the loan. Each installment payment includes both principal repayment and interest payments. It is usually taken for a specific big-ticket expense. As it is less flexible than a revolving loan in terms of tenor and repayment schedules, typically, the interest rates charged are cheaper.
A revolving loan comes in the form of an overdraft, or a line of credit. You are able to draw any amounts up to a specified maximum credit limit, and you can pay only interest so long as the line is drawn. After you pay off the amount drawn, the credit becomes available to draw on again. As the interest rates charged on a revolving loan are often higher than a term loan, use it sparingly and when absolutely necessary.
Do note that ‘balance transfers’, or unsolicited cheques mailed to you by your banks are revolving credit that usually taps on your credit card limits.
2. Consider the Whole Package
Don’t just settle for the lowest promotional interest rates (sometimes, even 0%). Promotional interest rates usually come with other strings attached, like:
- Processing fees
- Prepayment fees if you pay up the term loan before it is due
- Requirement to take up insurance for your loan amount
- Stepped-up interest rates after the promotional period is over
3. Applied Interest Rate vs Effective Interest Rate
Why are there 2 interest rates? One is almost double the other. So should I just consider the higher rate? Aiyoh, so confusing!
The lower applied interest rate (AIR) is usually the advertised rate, which may range between 7-15% p.a.
The effective interest rate (EIR) of a personal loan reflects the true cost of taking that loan, by considering whether a flat rate interest is charged upfront on the full loan amount, or whether it is charged on the reducing balance of the loan as it is paid down. In the monthly rest method of interest calculation, the AIR is equivalent to the EIR, because interest is calculated based on the reduced balance of the loan.
The EIR takes into account the frequency of repayments, and whether the instalments are in equal amounts. For a 1-year term loan, the EIR is higher if repayments are required monthly than if a lump sum payment is required at the end of the year.
Hence, always ask for and consider the EIR when comparing personal loan rates.
4. Interest Rates for Personal Loans are Generally Higher Than Other Specific Types of Loans
Personal loans are generic. They can be used for anything. They are also more expensive than a whole host of other loans for specified purposes, like:
If you do require a personal loan, Moneysmart is here to help you find the best personal loan for your needs!