Although never having to borrow money is a good goal to aim for, personal loans can be used to protect your personal finances.
Most of us are taught, from an early age, never to use loans. This creates a fear of financial tools such as personal loans or lines of credit.
That’s unfortunate, since loans are a little like kitchen knives - you shouldn’t give one to a child, but it’s hard for an adult to cook dinner without it.
Here’s how to use personal loans safely, and why it may not be wise to avoid them entirely:
Cash is King... or is it?
There’s an old saying that cash is king. Ultimately, when it comes down to the crunch, your financial preparedness is based on the amount of cash you can access. It’s possible to have a lot of money on paper, but be utterly broke - there’s no point having future cash (say by owning a financial product that will mature in 15 years), if a loved one needs chemotherapy right now.
Being low on cash also means you’re unable to seize opportunities. Imagine you have all your money tied up in, say, an insurance endowment plan. You’re then given an opportunity to pursue a higher paying job - but the condition is that you must leave your current employer, and receive lower pay for just the first year (a training period is involved).
Without sufficient cash flow, you may have to miss out on this opportunity. If you have children or a spouse to look after, for example, you may not be able to last a whole year on a lower income; nor could you take the risk of leaving your current employer.
In situations like these, loans can be a powerful tool to help.
Four Situations to Consider Using Loans
The main argument for using personal loan is to protect the cash you have on hand. Consider using a loan in the following situations:
- Protecting your savings from a total wipe-out
- Seizing opportunities with smaller cash outlays
- Fulfilling once-in-a-lifetime aspirations, without going broke
- Repaying low-interest loans
Protecting Your Savings From a Total Wipe-out
Say you encounter a financial crisis, such as having to renovate your entire flat after a fire, or being found liable in a court of law. This leaves you facing a S$50,000 bill. What can you do about this?
The first method would be to tap your life savings, and potentially wipe them all out. This is both painful and dangerous. It can take you many years to rebuild your savings; and should another incident occur, you’ll be too cash strapped to deal with it.
In particular, people with dependents (children, elderly parents, non-working spouse) should be wary of emptying their savings; you never know when a loved one will need immediate financial assistance.
In these cases, a loan may be the better choice. You could, for instance, take out a loan for S$50,000, and pay back a S$1,600* per month for three years. While this does mean paying more, it also means your savings won’t be wiped out - you’ll still be prepared for emergencies, should they come around.
*The loan repayment amount will vary based on the interest rate. Use SingSaver's handy comparison tool to find the lowest interest personal loan now!
Seizing Opportunities With Smaller Cash Outlays
Opportunities can come in many shapes and forms. They may be investment opportunities, a chance to go abroad on an exchange programme, or a chance to pursue higher education.
Usually, the main obstacle to seizing these opportunities is the cash outlay - the amount of money you need to pay for them, at least initially. The eventual returns may sometimes be higher than this.
For example, there is a high cash outlay to get a university degree; it may cost upward of S$40,000. Over time however, you could get a higher paying job with your education, that would more than make up for it.
This initial cash outlay can put us in a dangerous situation. For example, if you were to spend all S$40,000 at once to get a degree, you would be living on the edge for the three to four years during which you pursue it. If something were to go wrong, you might be forced to abandon your studies (and money worries could affect your grades).
This is where a loan can help. Many education loans don’t even require repayments until after you graduate, so you’re already earning an income before you need to pay back the bank. And while you’re studying, any savings that you have are untouched, and available for sudden emergencies.
Fulfilling Once in a Lifetime Aspirations (Without Going Broke)
We all have important aspirations of some sort. This could be a religious pilgrimage, or a desire to take part in high-level competitive sports (which may require a significant investment of time and money).
If we only rely on cash reserves, it could be financially imprudent - and in fact irresponsible - to pay for such ventures. It’s not a good idea to jeopardize your family’s finances, for example, for your own aspirations. And yet, you may not be able to recognise your dreams without the high initial sums.
Loans provide an alternative to this. You can take out a loan to fulfill your aspirations, without spending a dangerous amount from your savings or your family funds. The key is to ensure that, when you do this, the loan repayments do not extend beyond 30 per cent of your monthly income.
For example, if you earn S$5,000 a month, the loan repayment should never exceed S$1,500 per month. If it would fall within this amount, it might be better to finance your aspirations with a low interest rate loan, rather than by emptying your existing savings.
Repaying Low-interest Loans
The most common example of this is your home loan. Never put your finances in jeopardy, by rushing to repay it without reason. For example:
Say you owe S$200,000 on your flat, and with great effort, you have accumulated savings of S$100,000. Should you immediately pay the S$100,000 into your home loan, to rush repayment?
The answer is probably not; consider that your net worth does not change:
If you have S$100,000 and you owe S$200,000, then your net worth is negative S$100,000.
If you rush to repay the S$100,000 into your home loan, then you will have $0, and you will still owe S$100,000. Again, your net worth is negative S$100,000. You haven’t really improved your financial standing by much.
However, the difference is that - because you put all your cash into a rushed repayment - you now have nothing on hand for emergencies. Should you be retrenched or fall ill, you cannot take money back out of your home loan*.
As such, it’s important to avoid the oversimplified view that loans must always be avoided, or that they must be repaid as quickly as possible. Loans are simply tools, and part of financial literacy is learning to use those tools correctly.
*There is a way to do this, called cash out refinancing, but not everyone qualifies. It is also impossible for HDB properties.