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Debt is often categorised as ‘good debt’ or ‘bad debt’ and, more often than not, personal loans fall in the bad debt column. Many financial commentators, like David Koch or the Barefoot Investor, list their first recommendation as avoiding or paying off personal loans as soon as possible.
While in general this can be true, there are circumstances where personal loans could provide a solution to a financial challenge. Additionally, some brokers fail to use them as a tool to add to their client base by working with their customers to meet their longer-term needs.
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So are personal loans bad debt?
The traditional, and non-accounting, definition of bad debt is using a loan to purchase an item that doesn’t grow in value or result in income over time (ie where the cost outweighs the benefit). But in our experience, the reality of which column a personal loan falls in should be determined by the individual’s personal circumstances, how they use the loan and the value they put on the benefits derived from the purchase (ie the cost paid in interest).
While savings should be the preferred method of funding purchases, a personal loan may be a viable alternative when there isn’t the luxury of time to accumulate the savings or the ability to turn to family or a partner for help.
When this urgency arrives, brokers should be able to easily provide a solution to customers, if for no other reason than to stop them going to a bank for the answer. The following are just a few recent examples that we have seen:
• Going to see your children play sport at an elite level when they are selected at short notice
• Purchasing a piece of medical equipment, heater or air conditioner to prevent a health condition getting worse and incurring a significant medical bill
• Consolidating debts to reduce monthly outgoings and get in control of your monthly cash flow
There are some other benefits that can be derived from a personal loan, including being able to demonstrate the ability to repay a loan for when that four-and-a-half-year-old default or that six-and-a-half-year-old bankruptcy drop off a credit file. How this plays out in a world of comprehensive credit reporting will also be interesting over the next couple of years too.
As this demonstrates, sometimes there is value put on a purchase or an expense which may not be obvious to a broker or where there is no other option in the short term, and it justifies a loan with an interest rate two or three times that of a mortgage.
Ultimately, like any financial decision and broking transaction, responsible lending is critical to this being suitable to the client. But before you write off personal loans as bad debt, consider whether they could be a real option for your clients and a new way for you to meet their needs.
