5 Questions to Ask Yourself Before Taking out a Loan
Anytime you borrow money, finance a purchase, or take out a loan, you should carefully consider if it is the right decision for you. Borrowing money means that you are committing to pay the money back within a certain time frame and at a certain interest rate.
Failure to honor those commitments could result in serious financial issues. That's why, before signing on the dotted line, you should consider how borrowing money could affect your future finances. You don’t want to gamble and guess at whether or not you can afford the payment, how it will affect your debt-to-income ratio, or if it fits into your budget.
So, while it may be tempting to accept the money without hesitation, pause and ask yourself these five questions before you take out that loan.
Is This Purchase Necessary Right Now?
All too often, purchases that seem necessary aren't really necessary upon further consideration. You can postpone most purchases until you have saved up the money to buy them in cash, rather than going into debt to make the purchase now.
For example, while doing your laundry at a laundromat is inconvenient, an in-home washer and dryer isn't a necessity. You will save money by paying cash for a new washer and dryer, instead of financing it and paying interest on the funds you borrow. Similarly, you should save up the money to buy recreational items like boats, because they are not necessary purchases.
It may be hard to restrain yourself from buying these items now, but you can use that as motivation to quickly save up for the purchases.
Can I Purchase Something Less Expensive Instead?
When you're already spending a significant amount on a purchase, it's tempting to go all out—opting for the nicest model with all the extra features. However, when you're going into debt for a purchase, it's smarter to scale back and buy a used version, an older model, or otherwise seek out cheaper options.
For example, if you are purchasing a car, you may consider getting a more basic model or a used car, instead. Whatever money you save, you can put those funds toward saving for your next big purchase (or paying off debt if you had to take out a loan for the original purchase).
Do your research on major purchases so that you know you are getting the best value for what you can afford to spend. This does not mean that you necessarily buy the cheapest item available, because you do want something that will last and be worth the price. Doing research can help you find a balance between a quality product and a reasonable price point.
Can I Afford to Make the Payments?
This is an essential question to ask yourself, and it’s important to be honest as you answer it. Consider the limits that this purchase may impose on your financial flexibility in the future. You may not be able to take as many vacations, because you cannot save money as quickly. You may have to eat at home more often, rather than going to restaurants. You may have to skip out on happy hours with your friends.
If the financial constraints imposed by debt obligations are too restrictive, you may come to regret a purchase that you were originally excited to make.
One popular way of measuring how much debt you can afford to take on is known as the debt-to-income ratio (DTI). You do not want this to be higher than 25%, and that's for all forms of debt, including your mortgage. If your DTI is much higher than 25%, or if a new loan will push you too far over that ratio, you may not qualify for new loans.
How Fast Can I Pay It Off?
When you take out a loan, you need to be clear on all the terms and details of the loan, and that includes how long it will take you to pay it off. Remember, interest payments hamper any of your efforts to build wealth.
When you can turn this around and invest in passive income vehicles, then you will begin earning money with your money. This will help expedite your process toward your financial goals.
If you do decide to take out the loan, you should think about ways to pay extra each month, rather than sticking with the minimum monthly payments.
What Happens If I Can't Pay It Off?
If you don't have a significant amount of emergency savings set aside, you need to consider the worst-case scenario. If you do take the loan, how would a job loss or pay cut affect you in the long-term? This will add extra pressure to your job search because any late or skipped payments will affect your credit score and worsen your debt.
Depending on the industry you are in, you may have a difficult time finding a job if you have a poor credit history, so your debt will affect your ability to get a job and pay off your debt.
Before taking out a loan, you need to consider how you will pay this loan off if you were to lose your job. A spouse's income or another supportive family member may be able to help. If you are single or live in a one-income household, you need to be extra careful about any debt that you take on.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.
Experian. "What Is an Ideal Debt-to-Income Ratio?" Accessed June 3, 2020.