It’s still a week until payday, your daughter's been rushed to hospital from school in an ambulance with a suspected burst appendix, and you don’t have health insurance. This is the last straw for your overstretched finances. Do you decide to take advantage of a short-term emergency loan facility?
A short-term loan may seem appealing to combat unplanned financial difficulties. There are ads for various lenders popping up all over the place. We’re led to believe they’ll help us out of a bind. But what's the ultimate price we pay? Are they really the best solution?
Financial comparison website, Finder, has discovered these short-term loans are often used to fund car purchases, prepare for a baby, pay for a holiday, home renovations, or to buy jet skis or snowboards1. Unfortunately, these loans, coupled with an over-reliance on credit cards, can negatively affect your credit score. This can lead to borrowing costs being more expensive. Every increase pushes home ownership even further out of reach.
The urgency of emergency funds
Many of us have little in savings to cover an emergency. Life can throw you many curveballs and you don’t want a payday loan to be your only option. A great place to start is to establish a savings plan to build up an emergency fund.
While plan A is to make sure you have an emergency fund, life isn’t always that straight forward. To help the decision-making process, we’ve compiled a few things to consider when contemplating an emergency loan.
Good debt versus bad debt
A good rule of thumb when it comes to borrowing is to think of good versus bad debt. Generally good debt refers to borrowing to buy an asset or income stream. Using a short-term loan to cover water bills, holidays or big-ticket consumer items is bad debt.
Home ownership delayed
Short-term loans negatively impact your credit score. When you apply for a home loan, if you do get approved, you pay considerably more in interest, as a high-risk borrower. If your long-term goal is to own a home, be particularly mindful about opting for short-term personal loans.
Consider other options
The best option is to start now, before the emergency, to work toward building an emergency fund. $3,000 makes a great start to aim for (ideally an emergency fund is equal to approximately three months worth of expenses). Be mindful of your purchases and budget to not live beyond your income. If you should find yourself in a bind, be aware of other options available. For example, many utility companies offer hardship repayment plans, and no-cost microfinance providers can offer no interest loans schemes.
It’s important to be aware of the impact these loans can have on your overall credit rating. While a loan may fix a problem in the short-term, the impact long-term is significant.
When it comes to the next time you want to borrow, you could end up paying far more. According to Finder, consumers with a poor credit score and high-risk profile will pay $10,000 more in repayments over the life of a five-year, $30,000 loan than those with an excellent credit score and low-risk profile.
Learning what to do about credit scores now can make a big difference in the long run.
1 https://www.domain.com.au/money-markets/expensive-emergency-loans-make-home-ownership-less-likely-for-vulnerable-australians-771069/ last accessed 10 December 2019.
This article is general information only. Readers should consider getting financial advice before making financial decisions.