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Personal loans: Beware the debt trap

Posted by S Peer Mohamed (peer) on 8/17/2013 11:36:56 AM


They can help in times of need, but only take what you can afford

Dubai. Personal loans might seem like a quick way to pay for anything from university education, to vacations or even medical treatments. But beware: you can become trapped in debt if you borrow more than you can afford.

“In the UAE, people tend to use a personal loan to cover expenses, [buy luxury goods that they can’t afford] or to pay their debts,” said Preeti Bhambri, managing director and founder of Moneycamel.com. “But, loans should be taken to build assets or for emergencies.”

And, personal loans are unsecured, which means that whatever a borrower buys with it cannot be used as collateral to help recover the costs of the debt.

To manage debt well, borrowers need to estimate their future expenses and make sure they can comfortably cover the monthly installments. Even if eligible for a large amount, it is best to only take a loan that you can afford, Bhambri explained.

Borrowers should look for the lowest interest rate for which they are eligible. Banks usually offer ‘flat’ or ‘reducing balance’ interest rates. Steve Gregory, managing partner at Holborn Asset Management, said people are often unaware of the differences between the rates and financial institutions do not always explain them.

With a flat rate, borrowers pay a fixed rate of interest for the duration of the loan. But, with a reducing balance, borrowers pay interest on the amount due at the end of every month, Gregory explained. To choose a rate, borrowers should calculate the value of the loan they intend to take and how much are they will be expected to pay for the duration of the loan, said Gregory.

Bhambri recommends considering a reducing balance rate - the interest charge comes down as the principle of the loan is repaid.

Borrowers can also pay off their loans in a shorter amount of time at a lower interest rate, said Bhambri. However, this may come with extra charges, so borrowers must look closely at a bank’s repayment policy, she said.

There are also Islamic finance products available for loans for schools and university fees, houses, cars and haj and umrah, among others. Banks buy the product and then sell it to their customer, at an agreed profit after the monthly installments are completed. Customers are not charged interest.

The UAE Central Bank has said that banks should not extend loans with installments that make up more than 50 per cent of a borrower’s salary. There are institutions that offer loans of “a maximum of 20 times the borrowers monthly income” and repayment over 48 months. However, Gregory said borrowers should not pay more than 20 per cent of their salary to service a loan.

And don’t take a loan unless you are prepared for unfortunate circumstances in the future, like losing your job or getting your salary cut, Gregory warned. He also recommends looking at the insurance institutions offer with their loans: is it free, is it charged to the loan, and what does it cover?

For salary transfer loans, the borrower’s salary must be paid into an account at the bank that issued the loan. The bank will then deduct monthly installments directly from the borrower’s account until the loan is paid. “Since the bank has access to the borrower’s account, the risks [of this type of loan] are lower, so the interest rates are lower,” Bhambri explained. Interest rates on personal loans normally start at 6.5 per cent.

With a non-salary transfer loan, there is no requirement for a borrower’s salary to be deposited at the lending bank, but they must issue post-dated cheques to cover the installments. Borrowers must then make sure their cheques do not bounce to avoid penalties - like a late payment fee, among others.

However, an installment can be postponed if the borrower has a history of making payments on time and has made the necessary arrangements with the bank, well in advance. In this case, the borrower must pay an installment postponement fee, but avoids other charges, she said. Banks also refer loans to their debt collection department, or take the borrower to court, if the loan is not settled, Bhambri said. But, they normally give a grace period to borrowers, to give them a chance to pay off their loan.

Those who cannot settle outstanding loans face not being able to change jobs or having their visas cancelled.

Personal loans are generally granted to salaried and self-employed individuals. Banks look at the applicants designation and salary, Bhambri said.

Employees of large companies, tend to be given a loan even with a minimum salary of Dh5,000. Banks tend to trust such organizations as their employees usually pay off their loans on time, Bhambri said. Employees at companies that face more restrictions, would need a minimum salary of around Dh 10,000. Those working at small companies, perceived to be at higher risk, are not granted loans unless they transfer their salary to the lending bank.

Source: http://gulfnews.com/business/your-money/personal-loans-beware-the-debt-trap-1.1191742

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