Personal loans have become increasingly popular to obtain quick cash for various purposes. While they can provide immediate financial relief, it is essential to understand that personal loans come with risks and potential negative impacts on your finances.

Let's explore some of the adverse effects of personal loans and how they can affect your overall financial well-being.

What is a Personal Loan?

A personal loan can be defined as a type of unsecured loan that individuals can obtain from banks. Banks will assess your creditworthiness, financial history, and income to determine your eligibility and loan terms.

Unlike secured loans such as mortgages or hire purchase loans, personal loans usually do not require collateral, which is why it is unsecured and quite easy to obtain.

However, did you know that data from the Insolvency Department showed that nearly 42 percent of people who declared bankruptcy in the last four-and-a-half years mention personal loans as the reason leading to bankruptcy? 

One of the main reasons why personal loans lead to bankruptcy is the failure of borrowers to pay monthly installments.

As personal loans are easy to obtain, many apply for them recklessly to satisfy many of their needs or when they are in need of money, even if they can't afford to take the loan.

When the burden is too much to bear, they start to fail, and this will eventually lead to bankruptcy.

How Do Personal Loans Work?

A personal loan is easy to obtain as it does not require any collateral. As it comes with a high interest rate as compared to a house or car loan, it is easier to be approved.

Even though banks will evaluate your creditworthiness and financial history, the process is not as strict as other loans. The healthier your creditworthiness, the easier it is for you to get the loan, and sometimes, it is offered at a lower interest rate.

Before applying for a loan, there are a few details that need to be critically reviewed, such as interest rate and loan tenure, as both factors will determine your monthly installment.

For example, you will need to pay higher monthly installments for a 10-year loan with a 10% interest rate as compared to a 10-year loan with an 8% interest rate.

If the interest rate can't be changed, then you will need to consider the tenure of the loan. The longer the loan, the lower the installment, but the total cost of borrowings (principal plus interest) will be bigger.

Upon approval of your loan, you will receive a loan offer that will provide details of the loan, such as the amount approved, interest rate, duration, and total loan, which includes principal and interest rate.

The True Cost of Personal Loans

1.  Interest Rates

One of the most significant drawbacks of personal loans is the high interest rates, as personal loans usually do not require collateral. The higher interest will ensure that the bank is compensated if borrowers default.

A higher interest rate means a higher total cost of borrowing for you; as such, you need to think carefully before taking any personal loan.

Most banks in Malaysia charge fixed interest rates for personal loans, which are applied to the principal sum borrowed.

This will mean your interest costs remain the same throughout the tenure of your loan, no matter how much you’ve already paid.

Interest rates for personal loans in Malaysia start from 3% up to 18% with different terms and conditions.

Other than that, the loan also comes with late payment charges, which start from 1% up to 10% of the current outstanding. As such, every time you defer your installment, the charges will be added to your loan.

Understanding terms and conditions is very crucial as some of the most important things hide in between the complex words crafted in the letter offer.

Ask the bank officer for more information until you clearly understand the terms and conditions before agreeing to accept the loan offered.

2. Loan Tenure

The longer the loan period, the lower the installment, but the total cost of borrowing (principal plus interest) will be bigger.

As such, if you are considering a loan tenure, you will need to consider the overall cost of borrowing. If you are willing to bear the bigger cost of borrowing, then it is ok to opt for a longer period of loan.

However, it will be a lost to your financial standing as you need to pay more for the things that you acquired through the borowwings.

As such, if you have the ability to pay the monthly installment, it is advisable to take a shorter loan period to avoid paying a higher cost of borrowing.

Here's an example on how the loan period will affect the interest you end up paying:

As you can see, with a 10-year loan, even though the monthly payments are lower at RM708 compared to RM1,125 for a 5-year loan, you end up paying significantly more in total interest throughout the loan.

Difference Between Personal Loan and Ah Long (Loan Sharks)

When a person desperately needs money, some may turn to illegal money lenders, also known as Ah long or loan sharks. They offer quick loans outside the legal and financial systems without proper documentation and often charge incredibly high interest rates.

Below is the difference between a personal loan and loans taken from loan sharks:

It is better to avoid Ah Long as most of them are not legitimate lenders. Dealing with loan sharks is extremely risky due to their predatory practices, high interest rates, and aggressive collection methods, leading to potential harm, not only to the borrowers, but also their family.

The Impact of Personal Loan

1. Impact on your Financial Stability

Taking out a personal loan can lead to a cycle of debt if you are not careful. When you use a personal loan to cover your immediate expenses or to consolidate your current debt, it will add more burden to your finances.

As personal loan tenure is usually around 5-10 years, you will need to be sure that you have the ability to pay the installment for the long term.

2. Impact on your Credit Score

A personal loan can also impact your credit score, especially if you have a high debt-to-income ratio or miss payments.

It is important to ensure timely payments to maintain a positive credit history and financial stability.

A lower credit score can lead to difficulty obtaining favorable financing terms for significant life events, such as buying a home. 

People often view personal loans as a way out, an answer for immediate financial relief, or the easiest way to own things that they can't afford.

As it is easy to obtain, personal loan popularity has rapidly increased, along with other loan facilities such as credit cards and buy now, pay later, leading to a lot of financial distress in society.

As such, take great care before taking any loan and consider investing to build an emergency fund or to own things of your dreams.  

Take a step backward before taking any loan, and consider investing and building a fund to achieve your dream or to assist you during financial distress.

Instead of borrowing, why not invest, which usually can be done at a lower cost with a little of determination?

Key Takeaways

1. Even though easy to obtain, personal loans usually come with high interest rates.
2. Before taking any loans, consider these 2 factors, which are interest rate and tenure, as it will determine monthly installment.
3. Ensure you assess your finances to understand your current financial situation and ask yourself whether you need the loan.
4. Understand all terms and conditions and read the fine print, including interest rates, fees, repayment schedules, and penalties for late payment.
5. Consider other options, such as adjusting your budget and investing before committing to a loan.