by Simon Wright

Created on: March 24, 2009

Personal loans are sometimes lambasted as a great evil and as serving only to fuel our unhealthy lust for debt. However, such a stance is overly dramatic and there are some circumstances in which the prudent financial decision is to take out a loan. The key, therefore, is to rationally assess whether the reasons for taking out the loan are warranted when judged against the cost that the loan will involve.

In general, I would argue that there are two main scenarios which may justify the taking of a loan. The first is where you require to buy a large ticket item now but don't have sufficient cash available and are confident of your ability to make the payment in the future through loan repayments. The most common example of this is where people buy a car. In theory, it might be nice to save up until you have enough money to make the purchase but reality often isn't as convenient as that. For example, maybe your existing car is so old that keeping it on the road is costing you an arm and a leg. It's important that you have a car and taking out a loan is the logical way to meet your requirement.

The second scenario is where you have accumulated substantial debt across various debt instruments, such as credit cards and overdrafts. Consolidating all your existing debt into a personal loan can make sense as the interest rates on loans are often lower than you would get on a credit card or an unauthorised overdraft.

Where I become less comfortable with the use of personal loans is where people use them to cover more everyday costs, such as the expense of going on holiday. My view is that if I didn't have enough money for an expensive overseas holiday, I would opt instead for a cheaper holiday at home or else I would simply allow a longer lead time before my holiday so that I could save up for it. It feels, however, as if lenders have increasingly widened the scope of what they will allow people to take a loan for and some people get into the trap of funding a more expensive lifestyle than they can afford by ringing up large scale debt.

Part of my reticence over the use of loans to fund things such as holidays comes from my view that loans are best used where they will help you to secure something that will deliver long-term value. If I use a loan to buy a second hand car, I would hope that I will get several years of usage out of it. Or, if I use a loan to fund professional qualifications, then I am hoping that this will in due course enable me to get a higher paid job and therefore provide a return on my outlay. A holiday, on the other hand, is consumed and then provides no further financial benefit, although I do acknowledge that it may provide many great memories.

Where one draws the line on what is a good reason for a loan or a bad reason will vary from person to person but it is vital that you take time to assess why you are considering a loan, what the alternatives are and what you are hoping to achieve from the money. It's also important, of course, to note that the rate of interest being offered on the loan will go some way to determining whether taking a loan is the right approach. If interest rates are very low, then loans will become more attractive to individuals than in a high interest rate environment.

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