In most situations, it's a good idea to avoid going into debt. Sometimes, however, borrowing is unavoidable, or even smart.
You may want to take out a mortgage loan to buy a house, for example. This could make a whole lot of sense, since paying cash for a house is probably impossible -- or would tie up too much of your money -- and becoming a homeowner can help you increase your net worth over time. You may also want to borrow so you can finish your education or consolidate debt.
If you're thinking about taking out any kind of loan, however, there are a few key things that you need to do first. Here are four of them.
1. Make sure you understand the terms of your loan
Before you borrow, you need to know:
- What your interest rate is
- What the total cost of the loan is
- How long you have to repay what you owe
- What your monthly payment will be
- Whether your interest rate and/or monthly payment could rise
- What fees, if any, you'll be charged for the loan
- Whether you will be charged if you pay off your loan ahead of schedule
Unless you fully understand these things, it's impossible to know if borrowing is a good financial decision or a bad one. It's also impossible to know if you can really afford the loan.
Far too many people have taken out loans with variable rates -- meaning rates that can be adjusted -- without realizing that payments could rise and become unaffordable.
Borrowers who don't understand total loan costs may also not realize just how expensive borrowing is if they focus on monthly payments alone. You don't want to become one of those borrowers that pays too much for credit or even defaults on a loan, so don't borrow until you have a full understanding of what you're agreeing to.
2. Determine how much you really need to borrow
Even in a best-case scenario, borrowing costs you money because you have to pay interest. There's also an opportunity cost -- you're committing future money you haven't yet earned to paying principal and interest, so you won't be able to do other things with it.
Limiting the amount you borrow is important so you don't get overextended and commit so much cash to lenders that it's hard to accomplish other financial goals, such as saving for retirement. So:
- First consider whether you really need to take out the loan. If you're borrowing for something non-essential, such as a vacation or a big wedding, you likely shouldn't do it, and should just save up and pay cash instead. You only want to borrow if you truly have a pressing financial need, or if borrowing can improve your finances, such as when you borrow for a house or an education.
- Second, try to borrow the minimum needed to accomplish your goal. You'll want to save up a hefty down payment for a house, for example, or consider ways to reduce the amount of student debt you have to take on by going to a less expensive school or looking for scholarships.
If you can keep the amount you borrow to a minimum and avoid borrowing for non-essentials altogether, you can reduce the chances debt will become a major financial problem in your life.
3. Work the payments into your monthly budget
When you borrow, you commit to making payments for a certain period of time. Your specific repayment amount and your repayment timeline depend on the terms of your loan.
Make sure whatever payments you're agreeing to will be affordable for the entire life of the loan. Otherwise, you risk defaulting, which could ruin your credit and subject you to legal action. Find out from the lender what your monthly costs will be, and work this into your budget to make sure you're easily able to afford payments.
You may even want to try living on your new budget with the debt payment included for a period of time before you commit. This could help you to see whether you're taking on more than you can handle before you take on a debt obligation.
4. Compare different lenders
Finally, before you take out a loan, you want to find the best deal. There can be a lot of variation among lenders in terms of rates and fees, so try to get quotes from several different banks, credit unions, and online lenders.
When you shop around, try to pick lenders that will tell you loan terms without doing a hard credit check. A hard credit check means an inquiry is placed on your credit report and remains there for two years. Too many inquiries can hurt your credit score -- although lenders usually ignore multiple inquiries for the same type of loan in a short time because it's assumed you're comparison shopping.
Still, it's best to avoid having lots of inquiries when possible, so always see if lenders will give you details about the loan you could qualify for after a soft credit check only. That way you can pick a lender first, and only get one hard inquiry when you formally apply for a loan with your preferred bank.
Don't borrow money until you know what you're getting into
By making sure you understand what your obligations are, confirming you can afford your loan, and ensuring you're not borrowing more than you need, you can protect yourself from making a major financial mistake. Taking these steps is key to becoming a responsible borrower, so always go through this checklist before signing a promissory note for any loan.