My friend Sammy recently bragged to me about the luxury car he bought using borrowed funds. He proudly said his loan terms were 0% for 60 months, and his monthly payment of $995 is all principal, no interest!
Sound familiar?
Interest rates are low, and if you have a great credit score, many lenders are eager to offer you very attractive terms to borrow. Should you jump in and acquire the debt? Even after you've analyzed the costs from various sources and decided on the best offering, taking on a loan may not be a good move—at least, not without asking yourself these three questions.
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1. Why am I borrowing?
Dig deep and ask yourself the question: What are your real reasons for borrowing? Is it to get something you absolutely need, or are you borrowing to get something you may want?
Let us drill down to clarify what are needs versus wants. Are you looking to borrow to cover the expenses for a medical emergency? Is it to buy a car so you can commute to work? Is it to purchase your first home? These might all qualify as needs that would be well worth the debt.
Or are you borrowing to get a $995 a month luxury car? A vacation home on the beach? That expensive, state of the art, high-tech gadget that you hardly use? Those all sound more like wants that you should save up to purchase rather than borrow to get.
Financial Savviness 101: Don't borrow what you do not need!
2. Do I have enough cash flow to sustain the payments?
It is true that your lender has approved the loan after reviewing your current cash flow status. Does this really mean you can sustain the additional cash flow for the duration of the loan?
For example, consider Sammy's case above: He is required to cough up a payment of $995, not just this month, but for the next 60 months. That will have huge cash flow impact on him for the next five years! Let us see if he is prepared.
- What if he or his spouse lose jobs during this period? Will he still be able to cover the payment?
- What if his children are college bound in a couple of years? Will this payment disrupt his goal to fund his kids' education expenses?
- What if he or his spouse has a medical emergency during this period?
These questions are best answered by developing a budget, and then seeing how the loan payment could impact the budget. Kiplinger's Household Budget Worksheet is a great place to start.
3. What are the consequences if I fail to repay?
Borrowing comes with an obligation to repay according to the terms you agreed upon when you got into the debt. So, it is important to understand what could happen if some unforeseen circumstances force you to default on the loan.
Here are few consequences to consider:
- Your lender may report your late payments or defaults to credit bureaus impacting your credit score significantly. This could make it harder for you to obtain loans in future. Are you comfortable with this?
- As part of the debt agreement, your lender may have secured the loan with collateral. In other words, you risk losing the collateral if you default on the loan. Are you prepared for that?
- Your lender may hire a third-party agency to collect missed payments. Collection agencies use aggressive approaches to collect payments from you. This may impact your day-to-day well-being. Can you handle this?
- Your lender may sue you, and if you lose, the court may force you to sell your other properties or force you to pay back the loan from your employment wages. Have you thought about this?
So, what do you think? Do you know why you are borrowing? Do you know if you could sustain the payments? Finally, do you know the consequences if you default? It is not my goal to discourage you from considering a loan, but I hope to prepare you with these non-cost considerations of acquiring debt. Good luck!
Vid Ponnapalli is the founder and president of Unique Financial Advisors. He provides customized financial planning and investment management solutions for young families with children and for professionals who are approaching retirement. He is a Certified Financial Planner™ with an M.S. in Personal Financial Planning.
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