How To Choose A Personal Loan You Can Afford
February 11, 2021
Back in September, the Federal Government proposed a loosening of the current credit laws to make it easier for Australians to access credit when they needed it. At the time, Treasurer Josh Frydenberg said the changes would significantly cut red tape, allowing for freer lending to Aussie homes and businesses.
“As Australia continues to recover from the COVID-19 pandemic, it is more important than ever that there are no unnecessary barriers to the flow of credit to households and small businesses,” he said. “Maintaining the free flow of credit through the economy is critical to Australia’s economic recovery plan.” (1)
But, while many borrowers would welcome a little less red tape, experts argue that tape was put in place for a reason. Think about what happened with the GFC. One of the reasons it caused such havoc was banks and other lenders were able to lend more freely, providing credit to borrowers even when they couldn’t pay it back. So, post-GFC, lending laws were tightened up to place the onus of responsibility on lenders, in order to prevent the same thing from happening again.
Which is why now, when you apply for a loan, you have to provide detailed information regarding your financial circumstances, including how much you earn, how much you spend, and how much you owe elsewhere. The lender uses that information to determine your ability to take on more debt. If the lender thinks the loan will result in financial stress, your application will be declined.
However, opponents of the Government’s proposed changes say all that will be turned on its head with the relaxation of responsible lending laws. Reducing lenders’ responsibility and placing the onus back on the borrower when making the decision regarding a potential loan’s affordability, means it will no longer be ‘lender beware’, but ‘borrower beware’.
What does that mean for you? While the proposed changes are yet to take effect, if they are put into place, it will be up to you to take more responsibility when you apply for credit. In other words, you will need to become a more responsible borrower. Here’s what you need to know to make that happen.
Okay, so as we know, after the GFC, credit laws in Australia were tightened up. New procedures were put in place to reduce instances where borrowers could get approved for credit they couldn’t afford, while placing the duty of care on lenders.
Now though, some are saying these laws are too strict, given the state of our economy as a result of COVID. Back in August last year, Reserve Bank governor Philip Lowe weighed in on the debate, telling a parliamentary committee the legislation should be re-examined, saying, “The pendulum has probably swung a bit too far to blaming the bank if a loan goes bad”. (1)
Echoing this sentiment, Mr Frydenberg said, “Our current regulatory framework, with respect to lending, is not fit for purpose. It’s become overly prescriptive, and responsible lending has become restrictive lending.” (1)
Which is why, in September, the Government proposed certain changes to the credit laws currently in place. With these changes, new laws would be introduced that would reduce the verification procedures lenders currently use to determine each borrower’s ability to repay a loan, credit card or other form of credit upon application.
As a result, borrowers would not have to hand over as much information to lenders, essentially making it easier to get approved, while also speeding up the application process. The new laws – which will come into effect in March if they pass Parliament – will also make borrowers more accountable for providing accurate information to lenders when they apply.
However, there are many who say borrowers are not equipped to handle this level of accountability – and that the laws need to remain as they are to ensure those looking to borrow don’t get in over their heads by taking on too much debt. In other words, borrowers need to be protected.
On announcing the changes, the Government maintained strong consumer protections would be preserved – and credit providers would still need to comply with their existing licensing obligations to act efficiently, honestly and fairly.
Consumer advocates are worried this will not be the case though. In fact, some believe it will lead to a debt crisis. In November, a majority of Upper House members backed a Greens motion condemning the Government for attempting to wind back the laws and ‘water down’ consumer protections.
“The motion before the Senate highlighted that the Government’s proposed changes to consumer credit laws are inconsistent with the first recommendation of the royal commission,” Greens spokesperson Senator Nick McKim said. “The Government accepted this recommendation when it was handed down last year. Now they are abandoning it.” (2)
What recommendation was that then? According to Financial Counselling Australia chief executive Fiona Guthrie, “The very first recommendation of the report said the Act should not be amended to alter the obligation to assess unsuitability.”
“Commissioner Hayne made it very clear our responsible lending laws should remain unchanged,” she added. “The Federal Government accepted this recommendation, but it now plans to axe the law, meaning vulnerable people will no longer be protected from getting into massive debt traps.” (3)
Well then, the proposed changes to the laws certainly have their detractors. But, do those detractors have a point? Here are some arguments that have been raised.
They say: Lenders have already proved to be irresponsible
Under the stricter lending laws currently in place, there have been lenders who have still managed to prove themselves negligent in their duty of care, providing credit to those who could not afford to pay it back. A number of these cases were presented during the royal commission.
So, it stands to reason, if the laws are wound back, there would be even more room for irresponsible lending.
The Consumer Action Law Centre helped numerous commission witnesses through the process of providing their testimony. “The Treasurer’s proposals are a real slap in the face to anyone who gave evidence at the royal commission,” the centre’s policy director, Katherine Temple, said. (2)
“The royal commission showed the banks can’t be trusted to do the right thing and these proposals are essentially giving them more power and less responsibilities.”
They say: We are not good at judging our own financial circumstances
How much money do you spend in a week? A month? A year? Most of us underestimate how much we spend. We often forget about all the little purchases that add up over time. We tend to put aside the larger purchases, saying they’re ‘one-offs’, and that they don’t really count towards our budget. We overlook subscription costs, we downplay bills. We just don’t pay attention.
Which is why, overall, we tend to spend way more than we think we do.
Why does this matter? If you are the one who is in charge of deciding how much you should borrow, then knowing how much you have available to make your repayments each month is crucial. If you think you spend less than you actually do, the amount you have left over to cover your repayments will, as a result, be less.
“We’re not great judges of our own financial circumstances,” Ms Temple said. “We tend to underestimate our expenses and overestimate our income. That’s just a behavioural bias that we all have.”
Unlike us, though, “Banks can make use of the very rich data they have to assess whether people can afford to repay these loans.”
They say: It will lead to reduced protection for the vulnerable
One case that was presented to royal commission involved a young man with Down syndrome, who was aggressively and unwittingly sold several insurance policies he did not understand after answering an unsolicited call.
Baptist Minister the Reverend Grant Stewart spoke from the witness box on behalf of his son during the royal commission in 2018. On hearing the proposed changes, Mr Stewart said, “Given the amount of effort that was involved in putting the royal commission together, in the amount of people who gave evidence… it does seem to me we should honour that process.”
“Any reduction of lending protections might affect the wider community, particularly those who are most vulnerable and at risk to unscrupulous sales or advertising.” (2)
They say: It will lead to increased financial stress among borrowers
Last week, a report was released by peak body Financial Counselling Australia, which revealed that not only did the vast majority of counsellors surveyed want the laws to stay, but that many have used those laws to get better outcomes for clients struggling with debt.
Financial counsellor Kane Johnson, who works on the National Debt Helpline, said, “It’s not uncommon for me to talk to people contemplating suicide because of the debt situation they’re in. A lot of the time they’re calling with no idea of how to handle their situation.”
“With these laws in place we get calls on a daily basis from people so stressed they can’t sleep, their mental health exacerbated, a huge impact on their lives… and that’s with these protections in place. It’s just going to happen on a much wider scale if these laws are eradicated.” (3)
They say: There’s an increased risk right now of over-borrowing
With interest rates currently sitting so low, experts are worried borrowers may take on more debt than they should. Unlike lenders, who are obliged to take potential rate rises into account when assessing an application, borrowers may neglect to think about how they could afford their repayments should rates rise as they repay their loan.
Released in January, an internal Reserve Bank report outlined the negative effects of long-term low interest rates, effectively strengthening the case for retaining responsible lending standards. In the paper, the RBA found an extended period of low rates could prompt families to take on too much debt if accompanied by “looser lending standards and/or optimistic assessments of risk”.
Becoming a Responsible Borrower
It’s yet to be seen whether the proposed changes will be put in place – and what effects may be experienced as a result. With that being said though, you don’t have to wait for new processes and procedures to be implemented, for you to become more responsible with your borrowing.
While the laws remain in place for now – ensuring the onus of responsibility stays on the lender – you can work on becoming a more responsible borrower when you apply for your next personal loan – or any other credit product for that matter. Here’s how.
Step 1. Take an in-depth look at your finances
We know, the idea of taking a deep dive into your finances is perhaps not a pleasant thought. While you probably know roughly what you are spending and how much is coming in, it’s likely you won’t know exactly what you are spending and where. This is the time to find out.
If you want to check out one of the many budgeting apps currently available, this will make the job of tracking your spending much easier. These apps work to break down your spend into categories, so you can see exactly how much you are spending on a daily, weekly or monthly basis within each category, giving you nowhere to hide.
If you prefer to go the old school route, you can use a spreadsheet to note down each transaction from every account you use. Don’t forget to include your credit cards, everyday accounts and buy now pay later services, as well as subscriptions, bills and other ongoing payments. Track your spend for at least a month to get a good idea of where you stand.
Step 2. Be honest about what you can afford to pay back
While the first step may have been brutal – and perhaps, somewhat eye-opening – you should now have a better idea of where you stand financially. You know how much is coming in and how much is going out. Which means you should also know just how much you can afford to pay out in repayments on your new loan.
With this info, you can start playing around with loan options. While you won’t know your loan rate until you’re approved, you can use each loan’s advertised rate to give you a rough idea as you compare loan costs using a personal loan calculator. This should also allow you to compare repayment costs over varying loan terms, to create a repayment schedule that fits your budget.
TIP: If you’re applying for a loan to consolidate your debts, think about which debts you want to roll into the new loan. With those debts paid off, the money you would have once had to set aside to cover those repayments can now go towards paying off your new loan.
Step 3. Be conservative in your decision
Credit providers have a commitment to responsible lending. That means they only lend to applicants who have proved their ability to repay the loan. As a responsible borrower, you should be similarly conservative in your decision, choosing only to borrow what you can afford to pay back.
If you think your repayments might be a bit tight, you may want to consider borrowing less or stretching the loan over a longer period to create a more affordable repayment schedule. With that being said, don’t commit to an overly long loan term, paying out more than you should in interest. If you can’t afford it, rethink your decision to borrow.
Step 4. Consider the potential for rate rises
Just because rates are low right now, doesn’t mean they’ll stay that way. Rates can go up or down at any time. And, while rates may be influenced by the official cash rate, the rate you pay on your loan will always be determined by your lender. If your lender decides to raise your rate, it can do so at any time, according to the terms of your loan contract.
Before you commit to a loan, try to think beyond your approved rate and repayment schedule. If rates rise over your loan term, make sure you will still be able to afford your repayments – and that the increased amount you have to pay won’t cause you financial stress.
Fixed Rate or Variable? Of course, your rates only have the potential to change over time if you opt for a variable rate loan. If you choose a fixed rate loan, you can lock in your approved rate for the life of the loan. While this may appeal to you, there are pros and cons to choosing a fixed rate option – just as there are pros and cons to choosing to go variable.
Fixed Rate Loans
Variable Rate Loans
Step 5. Compare the options to get the best deal
Spend time comparing loan options to ensure you choose one that fully matches your needs. While the process of comparing personal loans can be tedious – especially as you get into all that small print – it should help you choose the loan that works best for you.
As you compare, think about what you want from the loan now – and how that may change over time. If you think you might want to make extra repayments or pay off the loan early, choose a loan that allows for this without penalty. If that kind of flexibility isn’t required, opting for a basic loan with fewer features could offer a lower cost option.
TIP: At Creditworld, it’s our job to make the comparison process less time consuming and tedious. You tell us what you want, and we provide you with a range of options that match your needs, from our panel of lenders. While you will still need to decide which of those options works for you, the process of finding and comparing personal loans is significantly easier.
Step 6. Don’t borrow if you can’t afford to pay it back
Before you sign on the line, take a step back to make sure this really is the right decision for you. Will getting this personal loan put you in a worse position financially? Can you comfortably afford the repayments both now and in the future? Is there anything on the horizon that may affect your ability to repay the loan?
Consider all aspects carefully to make sure the loan is 100% the right choice for you.
If you think the personal loan may simply be a Band-Aid for more serious financial problems, it may be worthwhile contacting a financial counsellor before committing to a loan. A good starting place might be to call the National Debt Helpline on 1800 007 007. This is a free service, open from 9.30am to 4.30pm, Monday to Friday.
Disclaimer: The information contained within this post is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.