Taking out a loan can have a lot of advantages. It can help you purchase something you otherwise wouldn’t be able to afford, like a house or your college education. It can give you access to financial leverage, increasing your investing power without demanding an increase in available capital. And in an inflationary environment, the debt you hold from alone could actually be a good thing.
But at the same time, loans can be financially destructive. If you’re not careful, one bad loan could completely ruin your finances and set you up for a lifetime of debt.
Shopping for a Loan Responsibly
This article isn’t meant to suggest that loans are a bad thing. In fact, when used responsibly, loans can be an excellent financial tool; there are also loan-like financial products that offer the advantages of loans with few of the drawbacks, such as settlement loans for personal injury cases.
You were taken away from this article shouldn’t be that loans are bad, but that it’s imperative to shop for a loan intelligently and responsibly.
How a Loan Could Hurt Your Personal Finances
How could a loan hurt your personal finances?
– 1. The interest rate. The biggest problem for most people is the interest rate. Most conventional loans charge an interest rate to compensate the lender for the risk of lending the money. This can be a fair transaction on both sides, since it grants the borrower extra purchasing power and allows the lender to make a profit simultaneously.
But egregiously high interest rates can be a major problem. Say you take out a $1,000 loan with an interest rate of 20 percent, compounded annually. After a year of not paying the loan, you’ll owe an additional $200 in interest, meaning you’ll owe $1,200 total. After two years, you’ll owe $1,440.
After 10 years, this compounding effect will make you owe nearly $6,200, more than 6 times what you originally borrowed. Even at a low interest rate, with on time payments, many borrowers end up paying several times what they initially borrowed in interest.
– 2. Excessive fees. A similar problem comes from excessive fees. Some banks try to make extra money by charging fees for a variety of loan related services and as penalties for misconduct. For example, you might owe hundreds or thousands of dollars in loan origination fees or other startup fees for the loan. You might face strict late fees and other penalties if you miss a payment. You might also face a flat fee for taking out the loan, which can be excessive.
– 3. Support of bad habits. In some cases, personal loans have the indirect ability to support your bad habits. Let’s say you budget incorrectly for the month and end up spending too much money on things you don’t need. You end up with a shortfall, meaning you’re no longer able to pay rent. You take out a personal loan to close the gap, and you get away with the bad habit by paying a small extra fee in the short term. It doesn’t seem like that big of a deal, but if you keep repeating this behavior, you’ll never improve financially.
– 4. Monthly expenses. If you take out a major loan, you might feel the effects on your personal finances every month for the next several years. Taking out a $20,000 loan for a car may not seem like a big deal initially because you’re only putting $1,000 down, but when you end up paying hundreds of dollars a month, suddenly less of your monthly budget is available for your other wants and needs. You end up financially restricted and less flexible.
– 5. The credit impact. Don’t forget about the impact on your credit score. If you make all your payments on time and you engage with loans responsibly, loans can actually boost your credit score. But if you’re not careful, missed payments, late payments, and delinquent accounts can all negatively affect your credit for many years.
Tips for Using Loans Responsibly
If you want to use loans to their greatest advantage, these are some of the most important tips to follow:
· Evaluate your needs carefully. Do you really need to take out a loan? Do you really need that expensive purchase?
· Shop around. There are many different lenders with different types of loans and different terms. Shop around to find the best fit and don’t be afraid to negotiate. You can almost always find a better deal than the first option you stumble upon.
· Be prepared for both short-term and long-term impacts. Try to think about both the short-term and long-term impact of your loan. How will your interest rate affect you? How will your monthly payments change your monthly budget? What’s your credit score like, and are you in a position to make on-time payments consistently?
Loans aren’t always necessary. When they are, they can be advantageous to your financial future. Think ahead, plan carefully, and only take on loans when you feel confident you can use them to their fullest potential.
