Why do you need to borrow?

There are many reasons that individuals, corporations and businesses borrow money. For most people, even with great financial discipline and adequate planning, taking up a loan is inevitable. For instance, loans are a way to finance huge capital investments like buying a car or home.

Whatever the reason for borrowing, incurring debt through a loan is a major financial responsibility, and one that requires adequate thought and planning. Once you get into debt recklessly, you can easily find yourself swallowed up in a mountain of debt. However, this is avoidable by carefully thinking about your borrowing and controlling how much you borrow.

Even where you qualify to apply for a much bigger loan, only take the amount that is enough to meet your reason for borrowing. Do you really need the item for which you are incurring debt? Do you need it right now? Can you afford to make the loan repayments throughout the period on time, apart from meeting all your other financial obligations and expenses?

If you can hold off on a purchase, then do so until you are in a better financial position, or save up for it to reduce the amount you have to borrow. Remember that over time, the interest payments and other charges can grow into a lot more than the original amount borrowed, especially if you repay the loan for a longer period.

Factors to consider before taking up a loan

  1. The repayment plan

There are two ways to consider how much to apply for a loan: how much do you need and how much can you afford? When you can afford a bigger loan, only apply for the amount that you need to meet your need. When your need exceeds what you qualify for, only apply for the amount you can afford, or hold off on the project until you are in a better financial position.

Every loan must be paid back according to the repayment schedule – on time and in full – regardless of your personal circumstances. Even if you get laid off, take a pay-cut or have to foot a large expense that was not planned for, you must keep up with the repayment schedule. Failure to do so will attract additional penalties such as late fees, which will leave you in a worse position.

Examine your current budget to determine how much is left over for loan installments after you have met your current financial obligations and personal expenses, including savings. Include a small allowance incase the expenses increase over the life of the loan. Also, include a buffer allowance where you take up a floating rate loan to cover interest rate hikes.

  1. Savings

Even if you are footing the expenses of a loan, you should ensure that you still keep up with your savings plans for your various financial goals. These savings will act as a cushion in case you have unplanned events, like losing your job or your partner losing theirs.

Before taking up the loan, see if, in the previous month, you can save the full amount of the loan instalment without adversely affecting your budget. Also, remember that where you are using some collateral to secure a loan, financiers will require you to pay the difference in value in case the fair market value of the collateral falls.

As a general guide, once you factor in credit card payments and other debt-related obligations plus the loan you are about to take, they should not add up to more than 35% of your monthly gross income. Remember that this is only a general rule; where you have more expenses, the debt to income ratio will be much lower than 35%.

  1. How much will you be paying back?

Before signing the dotted line, ask for a full schedule of repayments in order to get a rough estimate of how much you will pay back by the end of the loan period. We say estimate because a lot of factors determine how much you end up paying in the real world.

As a general guide, paying interest for a longer period is more expensive than for a shorter period. Therefore, you should try to make your repayment schedule as compact as possible by making the biggest payments you can afford.

You should also find out charges related to early settlement. Banks typically penalize you for  paying large sums to reduce or finish the debt ahead of time, since you deny them interest that would have been earned on the amount. Make sure you know what the penalty is for making payment before the loan period is over.