Should you pay off a debt with a personal loan or borrow from family and friends?
Taking a loan from family and friends may seem like the best solution to refinance or pay off a debt, but many people aren't aware of the strings or complications attached.
Things can get awkward a lot faster than you think.
So before you call up your loved ones asking them for a line of interest-free credit, you might want to consider the non-financial costs of taking out a loan from family and friends.
What to consider before taking a loan from family or friends
Work out a repayment plan for the loan
When you borrow money from family or friends, there's naturally less urgency with repaying the loan because you think "Hey, it's not like I'm running off anywhere with their money".
However, a trivial attitude and lack of clarity with the repayment terms for the loan can spell real trouble for your relationship with your loved one down the road.
Do yourself and your loved one a favour and take the time to sit down with them to formulate a repayment plan. For example, when will you repay the loan in full? How much will you pay per month? Will you pay interest?
Find common ground and figure out something agreeable and realistic for the both of you.
While it might feel awkward to have such a business-like conversation with a relative or friend, you'll be glad you carved out a plan which saves you many more awkward conversations ahead when it comes time for them to collect.
It's always best to have payment terms in writing so you can both refer to them if any problems arise later on.
What if I can't repay them on schedule?
This is what gets tricky with a loan from family or friends. What happens when you can't repay them on time?
While you may think that you'll be able to refinance the loan on time when you first ask for it, it's easy to lose track when you have other financial commitments to see to.
The fact that there probably isn't an interest rate on loans from loved ones means you're logically going to place it as low priority compared to other debts you need to refinance.
Having a clear repayment plan is all well and good, but this means nothing unless you can actually keep to your payment deadlines and stay on track. If for some reason you can't, it's a recipe for a lot of awkward family gatherings and less than friendly meet-ups for the foreseeable future.
What if they need the money back sooner than expected?
Despite setting a stipulated time period to return the money, life always happens.
Your relative or friend could lose a job, they could decide to pursue their studies, they could find a home they'd like to put a down payment on. Their financial commitments will continue to change during the course of your repayment duration.
This can put pressure on you to repay them sooner than planned. Unlike a personal loan where the repayment dates are fixed with the same interest rate throughout, the terms of a loan from family or a friend will sometimes need to change.
This is a huge consideration to keep in mind before you take a loan from them.
The repayment terms you set out for the loan with your family member or friend may not be the terms you'll be pressured to follow later on should they need the money back sooner than expected.
Will you feel emotionally indebted to the lender?
While you technically owe the lender a financial sum, what's risky about borrowing money from relatives or friends is feeling emotionally indebted to them as well.
You might just owe your loved one money, but in the meantime, while the loan is still being paid off, would you feel obligated to say yes to every non-monetary request they had?
He or she needs their car serviced, would you mind dropping it off at the service centre? They're away for a week and need you to dog-sit, would you mind doing it?
While you might actually not want to go out of your way to do them these favours, it's easy to fall into the trap of feeling indebted to them because of the pending loan and simply agreeing to everything they ask of you.
So before you take a loan from family or friends, it's good to be aware that there are emotional consequences that might follow you around for a long time or at least until your debt is paid up.
Alternatives to borrowing money from family and friends
With the emotional entanglements that come attached with a loan from family and friends, you might want to first take a better look at what your other options are.
Credit cards are probably the least ideal way to refinance a payment, simply because interest rates are normally the highest.
Some credit cards do offer a 0% or lower interest rate period of up to a certain number of months, but if you opt for this repayment method, you'll need to be super strict with yourself about repaying the full amount within the 0% interest window.
Once this window passes, you will need to start paying a much higher interest rate for every month the amount you borrowed goes unpaid.
Interest rates for credit cards in Singapore can fall anywhere between 19% to 26% p.a. and if you're not careful to pay your credit card in full each month, your debt can quickly snowball before you even realise it.
Just know that you do have other options of credit available to you, so do try to save credit cards as a last resort or for when you're absolutely certain you can pay back the amount in full within the 0% interest period.
Debt consolidation plans
If you're borrowing from family and friends as a last resort in order to pay off various debts you currently have, you might want to first consider a debt consolidation plan.
Debt consolidation plans, better known as DCP loans, are a type of repayment scheme and a great way to get your unsecured debt under control. DCP loans allow you to combine all your credit card debt or other unsecured credit lines, and personal loans from various banks into a single loan at one bank.
With this single DCP loan, you'll have a much lower interest rate (between 3.98% to 6%) compared to credit cards or other unsecured credit, which can fall in the high 20s - up to 28.88% p.a. This gives you a better shot of realistically paying off your debt.
On the other hand, it's important to note that debt consolidation plans usually take much longer to pay off since you'll be combining all your current debts into a single larger amount to pay back over time.
As with DCP loans, a balance transfer is another way to pay lower interest on your debt. Balance transfers involve transferring your existing outstanding debt to either another credit card or a credit line account which has a lower interest rate.
Balance transfers can be very helpful at managing debt but only when used with caution. Best practice is always to repay the full amount within the 0% interest window.
While balance transfers typically have a 0% interest rate for a period of 3, 6 or 12 months, a processing fee between 1 - 5% is charged upon transfer.
Unlike personal loans where monthly instalments or payments are usually set at fixed prices, balance transfers allow you to pay as much as you want each month, provided you meet a minimum repayment sum of about 1 - 3% of the balance of the amount owed.
Of course, there is a catch to balance transfers. If you miss your minimum payment, late fees of between S$60 - S$125 can apply. And if you fail to pay the full amount back within the 0% interest window, interest rates can soar to between 18 - 26%.
Taking out a personal loan from the bank is one of the most common ways of financing a payment. If you need to make a big payment and don't have the liquidity or flexibility to pay it back right away, a personal loan might be your best option.
Interest rates are generally lower for personal loans than they are with credit cards, and so you'll have a more sustainable and realistic way of paying off large amounts over a longer period of time.
Do note that your credit score may affect the interest rate you get on your personal loan and so you'll want to make sure you're actively working on building a solid and stable credit history that does not raise red flags.
With personal loans, monthly repayments are usually fixed, and this amount will vary depending on the amount you've borrowed and the loan tenor. To make the process easier, you can set up a direct debit for payments and that way you won't have to worry about missing payments.
Ultimately, the decision of whether to take a loan from friends or family is a personal one.
While an interest-free loan from someone you know and trust might sound like a no-brainer, it's still really important to keep in mind the worst case scenario of this arrangement.
Money and debt can turn even the best relationships sour when both parties aren't on the same page. Is the loan really worth risking the relationship?
If you're still on the fence, why not start surveying some of the best personal loans with lower interest rates to give you an idea if you can manage your debt without having to involve family.