You may have a great credit score, and perhaps many lenders are eager to offer you debt. Should you jump in and acquire the debt? Not so fast. Acquiring debt puts you in an obligation to pay back in time and as per the terms of the debt. Moreover, if you fail to pay, there are consequences. Also, financial savviness 101 says, “You should never borrow more than what you can afford” and “you should get the best deal possible”. Accordingly, this blog post: to encourage you to think twice, thrice before getting into debt. Perhaps, the checklist below will help you in that direction. So, let us discuss: Here is what you need to know when you are acquiring debt.
Why Am I borrowing?
This is indeed the first question that you should answer before committing to the debt. In other words, you should be very clear about why you need the debt and what you are going to use it for. One simple way is to ask yourself: Is what I am buying with the debt a “Need” or is it just a “Want”? The answer to that question should provide you tremendous clarity. For example, if you are taking the debt to fund your child’s college education, perhaps you may decide it is a ‘Need’ for you. On the other hand, if you are acquiring the debt to buy a luxury car, perhaps you may decide it is not that important. It is all up to you. So, think about it and ask yourself: “What are the real reasons for you to decide to borrow?”
What are the consequences if I fail to repay?
If you are taking a loan, it is important to understand that you have an obligation to repay. Moreover, the repayment is expected according to the terms you agreed upon when you got into the debt. Accordingly, it is wise to be aware of the consequences of delaying payments or defaulting on the loan. It is important for you to understand what could happen if some unforeseen circumstances force you into such situations. So, what could be such consequences? Here are few scenarios to consider:
- Your lender may report your late payments or defaults to credit bureaus impacting your credit score significantly. When this happens, it might become harder for you to obtain loans in future. This might influence your future goals. Are you ok with this?
- As part of the debt agreement, your lender may have secured the loan with a collateral. What this means is: you risk losing the collateral if you default on the loan. Are you prepared?
- Your lender may hire a third-party agency to collect the missed payments from you. 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. Are you comfortable with this situation?
It is not the goal of this post to scare you to consider a loan, but you should be aware of all the consequences listed above to make an informed decision about acquiring debt.
Can I afford?
All right, you know why you are borrowing and thought about the consequences if you default. Now, what? Now is the time to ask: “Can I afford the loan?” While thinking of affordability, it is very common to make the mistake of just looking at current worth and current cash flows. In fact, your lender assesses these before agreeing to provide you the loan. This alone is insufficient to be on top of your game. You need to have a reasonable expectation regarding whether you can sustain the cash flow into the future. In other words, you need to consider few what if situations:
- What if my spouse or I lose our jobs? Can I still afford this loan?
- How does taking this loan fit with my other goals? i.e. does this loan impact the savings targets for my kids’ education and my retirement?
If you answered these questions and decided you cannot afford the debt, the decision is easy: simply do not borrow. On the other hand, if you can afford, you are ready to move onto the next step and analyze the “Real Cost” of the loan.
What is the “Real Cost” of the loan?
It is easy to fall into the trap of thinking the cost of the loan depends solely on the interest rate offered by your lender. This, in fact, is a myth. Your actual cost could be much different from that. A prudent financial decision is to assess this so called “Real Cost” for the loan you are considering. Moreover, if you have a choice among multiple loan offerings, you will need to compare the ‘Real Cost” of the loans and choose the best offering.
So, how do you determine the “Real Cost” of the loan? Simply put,
Real Cost = upfront costs + ongoing costs + Interest payments – tax breaks
No, this is not math, and I am not suggesting you derive a number for the Real Cost. However, the point is: looking at these various costs will help to make your decision easier. So, let us continue with these different costs and see what they mean.
Upfront costs are usually one-time costs that you incur at the time of obtaining the loan. You typically see these costs with home-related loans. For example, when you are taking a home mortgage or a home equity loan, there could be costs involved with the closing process of the loan. Your home appraisal, attorney fees and some other admin costs involved in the process are some classic examples. These costs could be hefty and impact your overall “Real cost” of the loan. Ignoring these costs is not a smart financial decision when you are evaluating a loan.
Ongoing costs are rare and are loan-specific. For example, if you have a pre-approved line of credit loan, your lender may charge you administrative fees periodically, or charge you fees every time you borrow from the loan. So, watch out for these costs.
Interest payments depend on the specific terms of your loan. More specifically, they depend on factors such as 1) the interest rate at which the loan is offered to you, 2) whether the interest rate is fixed or variable, and 3) if variable, when and how it may change and how high the rate can go.
Looking at the rate offered is relatively easy. So is to understand whether the loan is fixed or variable. However, it calls for additional due diligence when evaluating a variable rate loan. For these loans, the actual initial interest rate may be lower than their fixed counterpart and this might entice you into accepting the loan. However, you need to be careful. The devil is in the details.
A variable rate is usually tied to a benchmark that in turn is linked to changing interest rates. What this means is that your current low rate could go higher in an increasing interest rate environment. However, one point to note is that variable rate loans may have a rate ceiling attached to them. This caps the increase in your rate no matter what happens to the benchmark interest rate. So, it is important to know if your variable loan has such a ceiling and if it does, what that ceiling is.
Tax Breaks are great and may indeed reduce the cost of your loan. For example,
- mortgage interest on your first and second homes
- interest on home equity loan or home equity line of credit (a.k.a. HELOC)
- interest on your student loans
are all good candidates to obtain a tax break ( up to the limits stipulated by IRS). On the other hand, auto loans and credit cards loans offer no tax incentives. Accordingly, you might want to know what tax incentives, if any, are available to you when you get into debt or when comparing two loan products.
So, what you think? Is this enough food for thought to help you decide whether to acquire a debt? If you need additional help or guidance, please feel free to Schedule an appointment with me. I will be more than glad to advise.