Every financial decision requires careful consideration. Here's why.
Every financial decision -- from joining a gym to buying a car -- requires contemplation. The best way to make an informed decision is to gather enough information to make the right choice for you and your bank account. Here are five questions to ask before taking out a personal loan.
1. What's the interest rate?
Let's say you're taking out a loan for $12,000 with a repayment term of four years. You were hoping for an APR of around 8%, but the best you can find is 10%. It's easy to talk yourself into a loan, particularly when the interest rates are not too far apart and you are anxious to remodel a bathroom (or whatever you plan to do with the loan).
But let's look at the difference 2% can make. If you had snagged the 8% APR, your monthly payment would have been $293, and you would have paid $2,062 in interest over a four year period. Agreeing to the 10% APR means a monthly payment of $304. That extra $11 per month may not seem like much, but accepting 10% interest means paying a total of $2,609 in interest over the life of the loan. That's $547 extra dollars you could have used to plump your emergency fund or invest in your future.
The first question you should ask a lender concerns the best interest rate they can offer. The first question you should ask yourself is about how badly you need the personal loan and if it's worth taking money from another area of your financial life.
2. Should I worry about the repayment term?
How long you have to pay off a loan is called the "term." Some lenders offer the lowest interest rate to those borrowing for the shortest period of time, she rates are higher for those looking for a longer repayment term.
If you're hoping to keep your monthly payment low by extending the term, here are two things to keep in mind:
- You may end up paying more in interest than anticipated. Say you could have snagged a 6% APR on a $10,000 loan if you had opted for a 36-month repayment term. Your monthly payment would have been $304 per month and you would have paid $952 in interest over the life of the loan. Instead, you went with a 60-month loan term to keep your payments at $200. Because you went with the longer term, the lender charged an APR of 7.5%, and you paid a total of $2,023 in interest -- $1,071 more than you would have paid with a shorter loan term.
- While having a lower monthly payment may be attractive, taking longer to pay means having a higher debt-to-income (DTI) ratio for an extended period. If you have a low DTI, this does not represent a problem. However, if your DTI is nearing 36%, which is generally the threshold lenders like to see borrowers stay below, it could mean not being approved for another type of loan when you need it. Let's say your car dies a slow death on the side of the highway and you decide it's time for a replacement vehicle. A high DTI could prevent you from taking out an auto loan.
Before signing on to any personal loan, consider the pros and cons of the loan term.
3. Am I better off waiting?
The borrowers with the best interest rates are those with the highest credit scores. Once you find out your interest rate, ask yourself if you would be better off waiting until you've had time to raise your credit score. It will take time and effort, but increasing your credit score is doable and is likely to save you thousands of dollars in interest.
4. Do I really need a loan?
Sometimes, a lender will agree to a loan that is not in your best interest. If 2020 taught us anything, it's that bad things seem to come out of nowhere. We might think the economy is steaming along or that our jobs are secure, but anything can happen. Figure out how you would make the monthly loan payment if you were to lose your job, become seriously ill, or otherwise hit a bump in the road. If you're not sure of the answer, it's possible that you can't afford the loan just yet.
Like any financial decision, it's a matter of weighing wants against needs. If your basement is leaking and you're knee-deep in water, a personal loan may be the best path out of the problem. If you're hoping to remodel your master bath to resemble a spa you once visited, the project may not be critical enough to warrant a personal loan. This is particularly true if you don't qualify for the lowest interest rate and need to take time to raise your credit score.
Ask yourself how critically you need a loan. If the loan isn't for an emergency and you're not sure of the answer to this question, a personal loan may not be for you.
5. Should I consider an alternative?
Depending on what you plan to do with the loan proceeds, you may have other options. When it comes to paying for things, it's important to consider how to do that in a way that saves you the most money. Any money saved is money that can be invested in your future. Here are a few ideas.
Saving up for something you want right now isn't as fun but can be highly beneficial. Saving means not having to pay a penny in interest. It means feeling the satisfaction that comes with having a project paid for in full. Saving up also means having an extra cushion of funds put aside, just in case the world goes topsy-turvy before your project begins.
0% promotional rate credit card
If you have strong credit, there's a good chance that you may qualify for a credit card with a 0% promotional rate. The 0% rate typically lasts from 12 to 18 months (depending on the card) and can make it easy to accomplish small projects without paying interest. Imagine that you need to replace the furnace in your home and the entire project, including labor, costs $4,000. You would pay $333 (for 12 months) or $222 (for 18 months) by making equal monthly payments. A credit card with a 0% promotional rate makes it possible to cover a project without paying interest, an origination fee, or any other costs associated with personal loans.
Let's say you need funds to repair something, such as a leaky basement or new transmission. You qualify for a loan at a decent interest rate but are a little nervous about the monthly payments straining your budget. Taking on a side hustle until the loan is repaid in full may help you sleep easier at night. It may even be fun. Miss teaching? Try tutoring. Have a special skill like speaking a foreign language or computer repair? Teach it to others online. Knit baby booties like a pro? Sell them to others who are less inclined to do their own knitting. Side hustles are all about figuring out what you're good at and finding a market.
When we were kids, we didn't ask ourselves a lot of questions. After all, that would have prevented us from doing the fun stuff, like jumping in puddles or eating ice cream while dressed in white. As adults, we have to ask ourselves the tough questions. The advantage of asking a lot of questions and answering them honestly is that we are more likely to make the kinds of decisions we won't regret.
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