What we all need to know before borrowing
Just because we can afford the repayments doesn’t mean a loan is the best option. Getting into debt is quick and easy. Getting out is much harder and may take years. All too often the lure of easy credit becomes a problem that drags us down further.
Tip: We need to be wary of taking advice from the institution or person lending us money. They want us to borrow because they make money from the interest we pay.
What’s the true cost?
Deciding whether we can afford to borrow money to buy something involves more than just working out if the loan repayments are manageable.
For example, we may be able to afford to borrow money to buy a car, but what about the costs to register, run and maintain it? Plug all these costs into the budget before deciding if it's worth borrowing for.
There may be other ways to get what we want without borrowing money. For example, we could save or put things on lay-by and pay them off in instalments.
Borrowing to buy an asset
There are two kinds of assets – value builders and value losers.
Value builders are assets that are likely to hold their value, grow in value or bring in income after we’ve paid for them. So they can be OK to go into debt for. A house is the classic value builder (although houses can lose value, too).
As a rule, if we keep a house for the long term (more than 10 years) the value will increase or stay about the same. And, if we needed to, we could sell the house and pay back our debt.
Education can also be a value builder. It can improve our job prospects and our income earning potential.
Value losers are assets that lose value after we’ve paid for them, like a common car. Every year the car is worth less. Borrowing to buy a car can be a risky move, especially if it loses value faster than we can pay off the debt.
If we really need to borrow money to buy a car or any other ‘value loser’, one option is borrowing only part of the purchase price instead to keep our costs down.
Saving to pay expenses
Expenses are things that leave us with nothing after we've paid for them – like living costs, nights out and holidays. Paying for expenses from income or short-term savings is ideal.
It can be painless to pay for a meal in a restaurant on a credit card. But if we take a few months to pay off the credit card, the interest charged makes that meal more expensive every day the debt isn't paid off.
For Michael Price, the 2011 Canterbury earthquake brought a different perspective on his finances.
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Knowing all the options
When borrowing money we need to make sure it costs us as little as possible – why pay more than necessary? Even a small change in interest rates can make a big difference to the total we pay over time.
It pays to compare all the places that lend money. For example, a store will have different costs than a car yard.
It helps to have a think about:
- How much do I really need to borrow?
- How much interest and other charges will I pay?
- How much will my repayments be?
- How long will I be paying back the debt?
- How often will I make repayments?
- How sure am I that I want to take on this debt?
The trick is to keep the full cost in mind (which the lender must disclose by law).
Know the full cost before borrowing
Work out how much it will cost with interest included - our loan calculator can help.
