How to Decide if You Can Afford to Borrow Money:  Things to Consider Before Taking Out a Cash Loan

Borrowing money is one way to help you buy the stuff you need or want but taking out a loan can be a big deal, so before you commit to taking out a loan, of any sort, make sure you can afford to pay it back.

How loans work

It’s important to consider all your options before you borrow and to do this you need to make sure you understand how loans work, how much it will cost you to borrow money to get the stuff you need or want, and how you’ll pay that money back over time.

Whether you borrow from a bank, another financial institution or even friends and family, the loan is usually made up of three components:

• Principal – this is the amount you borrow from a bank or lender.
• Interest – the cost charged by the bank or lender for you to borrow the principal. This can be at a rate fixed for an agreed time or floating and therefore a changing rate.
• Fees – you may have to pay processing, setup or admin fees, or a regular fee for the service to borrow money.

Consider this before borrowing money

Taking out a loan can be great when you need an immediate infusion of cash, but it doesn’t come without risks. Credit cards, hire purchase, buy now pay later, personal loans, mortgages, student loans: debt comes in many forms. People get loans all the time for homes, cars, boats, house renovations, medical expenses, electronics, travel, holidays, celebrations like weddings, christenings, or birthdays, or new business ventures.

Borrowing money can seem like a quick fix, but when you borrow money, you are obviously required to repay the original amount, or principal, back, and in nearly all cases, you pay more than that. It can be very easy to slip into heavy debt without realising it.

Talking about interest

Borrow and you will pay interest, the money you pay for the lending service. You may get a low rate, but borrowing can be expensive and interest rates often change. Borrowing $10,000 for a year at 7% interest will cost you $383.00 in interest alone and a small change in interest rates can make a big difference in how much you have to pay over time.

Your loan interest rate might go up 3% for example. That might not look like much, but a change from 7% to 10% would cost you $550.00 in interest over one year. That’s an additional $167.00 and that could place a strain on household budgets. Are you set up to cope? Make sure you can handle the increased payments if interest rates go up before you sign anything.

The trick is to keep the full cost in mind. And, of course, using your own savings is usually better than going into debt.

A few things you should consider before taking out a loan.

• First: ask yourself if you really need the money. If you can live without it, then it might not be worth borrowing.
• Second: consider whether you can afford the repayments. Taking out a loan is a big responsibility, and you’ll be required to make regular payments.
• Third: think about the interest rate. The higher the interest rate, the more you’ll have to pay back in the long run.
• Fourth: consider the terms of the loan. The longer the term, the lower your monthly payments will be, but you’ll end up paying more in interest. It’s important to pay off what you owe as quickly as you can. This way you’ll minimise the interest you may get charged.

Taking out a loan is a big decision. Deciding whether you can afford to borrow money to buy something involves more than just working out whether the loan repayments are manageable. Just because you can afford them, doesn’t mean that taking out a loan is the best option. Debt can be a serious drain on your finances, so make sure you borrow shrewdly.

Knowing all the options

Before borrowing money, explore all of your other options and make sure you’re making the best decision for your financial future.

When you borrow money from a lender, you have to sign an agreement committing to pay a certain amount back each month or fortnight which you must pay back on time. Even if you borrowed money for something you bought years ago and now don’t want or need it, you still have to continue payments until the balance is paid in full.

Another point to remember is that when you apply for a loan, your prospective lender will want to check your credit rating. Each time a lender runs your credit history, it can negatively affect it. So, applying too often for a loan, or credit in general, can be bad for your credit rating in the long term.

Spending for the future

Lastly, if you owe money to a lender, bank, family member or friend, it will limit how much money you have to spend in the future. You might not think about it at first, but you are giving up some of your future income by taking out this loan. Borrowing money for something that might appear necessary or a fantastic idea at the time means that during the repayment period, you’ll be reducing part of your income or cash flow. It’s important to think about what you might need money for in the future.

Some things to consider before borrowing money are:

• How much can you afford to pay each month?
• Do you have a savings plan in place in case of an emergency?
• What is the interest rate of the loan?
• Are there any penalties for early repayment?
• How long will it take you to repay the loan?
• What is the total cost of borrowing?
• What will the interest rate be?
• Are there any fees involved?
• What could you use as collateral?
• What would happen if you can’t make the repayments?
• Could you be putting your home at risk?
• Will borrowing for a short period damage your credit rating?

These are just a few key questions, but they will help to give you a better idea of whether borrowing money is the best option for you. Is what you’re borrowing the money for worth it?

What should you consider before borrowing money

Whether you turn to a friend, family member, bank or another financial institution, it’s important to be aware of the implications. Choose a loan term that you’re comfortable with and that you can afford before you start and remember to regularly review your financial situation to check if you can increase your payments to break free of this financial burden faster.

Everybody needs to be aware of the dangers of borrowing too much and getting into debt. Getting into debt is quick and easy but getting out of debt can be much harder and may take years. All too often, easy credit becomes a problem and there may be other ways to get what we want without borrowing.

For information on independent confidential budgeting services or advice, visit www.moneytalks.co.nz.