Out-of-control debt can turn your life into a nightmare.
Is there such a thing as “good debt”?
Borrowing can be a useful tool and a lifeline in some situations. It can also lead to mounting debt, stress, bankruptcy, and even suicide. It’s easy to fall back on thinking “That would never happen to me, I would never mismanage debt!” or “The lender says I can afford this, so I will be fine”. In reality, intelligent and well-educated people are capable of making bad debt decisions, and lenders sometimes approve loans that do not make financial sense.
If you are considering a new loan, think through these four questions before you sign the paperwork.
Is this a “need” or a “want”?
We often confuse our “needs” with our “wants”. Case in point, “I need cookies”. Sometimes, our emotional connection to something is so strong that we rationalize it as a “need” even though we could survive without it. Many closets, garages, and attics are silent cemeteries for purchases that felt urgent and necessary at the time, but ended up unused and forgotten.
Of course, needs and wants are personal – which can make them quite messy. If food is a need, does cake qualify? You may need a car to get to work, but is a brand-new BMW the only way to meet that need? Clothing is a need, but is it possible you might survive without that $500 coat?
If you are spending actual money you have, impulsive buying decisions are somewhat less of a problem (although they can still lead to a slowdown in your savings pace and ultimately hurt your financial future). However, if you are considering applying for a loan to pay for something that isn’t a necessity, take pause. Be creative in searching for ways to honor what you want while taking care of your long-term financial health.
What is your plan for repayment?
“I will just pay it off over time” does not qualify as a repayment plan.
How long of a time will you need, exactly? What will be the monthly payment? Does that payment fit into your current budget, or will you have to compromise on something else to make those monthly payments happen?
You must look at all the facts before you can decide that the repayment plan is reasonable. Calculate the monthly payment amount and make sure your budget can handle it. If you think you can cut other expenses to make it fit, cut those expenses right now. Without a concrete plan, you risk being stuck in the land of barely making minimum monthly payments. Time equals money for the lender, which brings us to the next point.
How much will you pay back in interest?
Knowing how long it will take you to pay back the loan, calculate the total amount you will pay in interest. This is a big part of the cost of borrowing, and one you must be comfortable with before you take on the debt.
What’s hiding in the fine print?
Loan agreements vary in terms of their requirements. Some have insurance clauses that take care of payments if you become ill or unemployed (but also cost you extra). Others allow for an interest rate hike if you miss a payment. Don’t make the mistake of glancing over the documents and concluding that is all legalese that doesn’t matter. It does matter, and it will cost you if you fail to pay attention.
Questions to Ask Before Taking on Debt
In addition to considering whether the loan will fund a need vs. a want, creating a concrete plan for repayment, looking carefully at the interest, and reading all the fine print, I encourage you to consider the bigger picture.
How did you get here?
There are life situations that can lead financially prudent families to take on debt to pay medical bills or cover large purchases that are necessary. However, if you find yourself relying on credit cards or personal loans for day-to-day living expenses, take pause. You may need a budget, not another loan application.
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