Taking out a loan is a major commitment. It’s important to make sure you’re making the right decision before you take out any type of debt. After all, you could have to pay interest on your debt for years after you borrow the money. To make sure you’re making a smart decision, you should make sure you know the answers to the following questions before taking out a loan.
Am I Willing to Work Longer for This?
Every dollar you spend is one less dollar you can save or invest for your future. Each dollar you take out in debt ends up being more than one dollar you have to pay back at a future date because of interest. Are you willing to work longer to pay for the item and the interest?
Think about it this way. If you make $10 per hour and you’re using debt to buy a $10,000 item, you’ll have to work 1,000 hours just to pay back the principal. That doesn’t even include the extra hours you’ll have to work to pay for the interest on your loan and the taxes on your earnings. Calculate this each time you consider taking out a loan. You might find yourself deciding the item you’re going to take out debt to buy isn’t worth 1,000 hours or more of working at your current job.
Will This Purchase Increase in Value or Increase My Income?
Debt can be a very useful tool if used correctly. In general, debt can be good when it is used to buy something that increases in value. Taking out a loan to buy a car will always lead to a decrease in wealth because cars depreciate in value over time. For that reason, many people view car loans as bad debt.
However, buying a home with a mortgage may leave you in a better financial position down the road. Overall, most homes appreciate over time. Keep in mind, a home is not necessarily an investment. Most of the appreciation in value is simply your property keeping up with inflation. After you factor in other costs such as maintenance and upgrades, you would probably lose money on a home as an investment. However, the value of your home will likely increase over time, so the financial loss isn’t as great as it would be with a car purchase.
Debt can also be a useful tool when you’re using it to increase your income, such as when obtaining a college degree. You shouldn’t simply use these arguments to borrow more than you can afford to pay back. Many people take out student loans for degrees that add very little or no value to their career path. If a degree won’t increase your income, make sure you’re paying cash for any education courses you take. If you decide you need a loan, go to a reputable company with good rates such as Lending Club or Debt.com.
How Much Interest Will I Pay If I Buy This Today?
Sometimes you need to decide whether to take out a loan and buy an item today or if it’s better to wait to buy an item until you can save enough to pay in cash. One powerful way to help make the decision is to calculate the total amount of interest you would pay. Simply take the number of payments times the monthly payment and add in any fees. The result is the total cost of the debt. Subtract the cost of the item, and you’ll have how much you will pay in interest and fees. Is the amount of interest you’ll have to pay worth the ability to get the item today? Only you can make that decision.
Will Other Costs Increase by Buying This?
Many items you may buy with debt will increase other costs in your life, too. If you’re buying a new car, you’ll have to carry full insurance coverage. The additional coverage may be more expensive than the insurance on the car you’re replacing. If you’re buying a home, you’ll need to start paying homeowner’s insurance, property taxes, homeowners’ association dues and costs to maintain your new home. Do plenty of research to make sure you can afford these additional costs in addition to your new debt payment.
Can I Afford the Debt Payments and Meet My Other Goals?
You may not be able to afford that new loan you’ve been considering. Even if you can technically afford to make a debt payment each month, you may be neglecting other areas of your finances. Unfortunately, if you can’t continue working toward your other financial goals, you generally can’t afford to take out the debt. A common trap is reducing your retirement savings to be able to afford a home that is above budget. People think they’ll increase their retirement savings after they get their next raise, but few ever do. Even worse, sometimes that raise never comes at all.
Asking yourself these five simple questions could save you from a major debt mistake. They don’t take long to answer and could greatly improve the health of your finances.
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