To Borrow or Not to Borrow: Things to Consider Before Taking Out a Loan
Remember when your parents taught you that you could only get that candy or toy you wanted if you saved your pennies? Money-savvy adults know that saving before spending is still a good rule of thumb. Unfortunately, grown-up realities aren't often that clear-cut. While a cash-only approach to managing your money might be an ideal to strive for, opportunities and emergencies crop up -- usually at the times when you're least prepared for them. So how do you know when borrowing is a good idea and when it isn't?
Questions Lead to Best Borrowing Decisions
Will what I buy with this loan be worth the decrease in my overall wealth? The money you devote to monthly loan payments can no longer be used to save or invest. If the loan will enhance your wealth in the long run by providing you with something that will appreciate in value (real estate, for example) or something that contributes to your ability to make money (an education or an investment in your business, for example), it may be worthwhile. If not, re-evaluate the need for a loan.
Avoid borrowing money for things like clothing, furniture, entertainment, vacations and meals out. These items have transitory and fleeting value and will decrease your wealth without giving you long-term or substantial benefits.
Can I afford the costs associated with this loan? Evaluating how the monthly loan payment fits your budget, while an important consideration, is a shortsighted way to determine whether a loan is affordable for you. The real question is how will the loan affect your finances over time?
"If you make only the minimum monthly payment on your credit cards, you could be paying for that dinner 30 years after you digested it," says Marc Eisenson, author of The Banker's Secret . He explains that most credit cards require a minimum payment of just two to three percent of the balance, which means you may be required to pay only $100 a month on a balance of $5,000. At a hypothetical 21 percent interest rate, it would take 10 years and $7,000 in interest charges to pay off the original $5,000 you borrowed.
Is this the best time to borrow? What's the economy like? Have rates been coming down or going up? Does it look like the trend will continue? Try to time your borrowing for when rates are relatively low. If you can't avoid higher rates, plan to look into refinancing when rates do drop.
Is your income situation stable? Are you self-employed and subject to income swings? Is the company you work for particularly vulnerable to economic fluctuations? Some people believe that borrowing money while you look good on paper is smart, but that's only true if you can continue making payments on the loan when things are not so rosy. Otherwise, you're setting the stage for debt problems down the road.
Once you decide that borrowing makes sense for you, be sure your loan meets certain requirements.
- Get enough. Borrowing just less than what you need in order to save money on interest charges may not be as good an idea as it seems. Be realistic about how much you need to borrow and get a loan for that amount.
- Avoid pre-payment penalty clauses. If your lender will charge you money to pay off your loan before it's due, you may want to reconsider that loan.
- Use automatic payments to reduce finance charges. Many credit unions or banks will give you a small (a quarter of a percent, perhaps) reduction in the interest rate if you allow them to take the monthly payment out of your checking account each month.
It's not too late to follow some good financial advice. Start saving your pennies today and you'll be able to buy that toy you want without having to take out a loan.
Article by BECU.org