Loans allow you to make large purchases that are beyond your current savings and the credit limit on your credit card. That being said, the decision to borrow a large sum of money isn’t one to be taken lightly. A loan is a kind of debt that works in a manner different from the way credit debt does. Loans are installment credit where a fixed amount of money is borrowed that is repaid with fixed installments or payments over a set period of time. They involve an interest rate and repayment terms that determine how large the monthly installments are going to be. Common kinds of loans are car loans, mortgages, and personal loans.
Whether the loan is to cover a large life-changing expense, such as the purchase of a home or educational fees, a big indulgence in the form of a car, for experiences and travel, or to consolidate high-interest debt, a loan is a financial obligation that can have a far-reaching impact on your life. This is an important decision that you must think about very carefully.
The following are 10 questions that you must ask yourself before taking a big loan:
What is my current credit standing?
The first order of business is to check your credit report and credit score. Even though credit score is an important financial metric, a surprising number of people don’t know what theirs is. Nearly 30% of people who took a MoneyTips survey in 2017 didn’t know their credit score. Your credit score and report are very important markers of your financial health. You are entitled by federal law to a free report annually from each of the three credit bureaus (Experian, TransUnion, and Equifax).
When you apply for a loan from a bank or a credit union, an inquiry will be made on your credit report. This inquiry is done by lenders to see how reliable you are handling debt and your finances. They may also have minimum requirements pertaining to your credit score. These precautions are taken by a lender to determine how much financial risk you are and the probability that you will not default on the loan.
Your credit score is very important, as it will play a big role in determining your rate of interest for loan repayment. If your credit score is low, the lender is most likely to offer a loan at a higher interest rate to balance the risk of you defaulting. You will find it very difficult to negotiate favorable terms that will result in low monthly payments and then substantial overall savings. If your credit score is on the higher side, however, you will be in a position to negotiate better terms for your loan.
Also, reviewing your credit report will help you understand how this large loan can affect your credit in the future. Any delay in or hindrance to making payments on the loan will have an adverse impact on your credit score.
What is the purpose of this loan?
The larger the loan, the longer it will take you to pay off. Borrowing money can make your life easier or come haunt you in the future. This makes the reason behind you taking a large loan something that you should give most thought to.
Ask yourself: why do you really need this loan?
A large loan can be used to make sound financial decisions. The thing to keep in mind is to borrow only the amount that is essential. As long as you stay away from impulsive purchases and living beyond your means, you remain reasonably protected from bad debt. There are considerations to be made even when seemingly well-thought out purchases are involved.
A mortgage is probably the largest loan you will ever take. It can be tempting to borrow a bigger amount for a more lavish property with more frills because you’re going to be stuck with mortgage payments for a very long time anyway. However, if you are not in a position to make a substantial down payment on your new home, then the interest on your principal can prove to be debilitating.
About 31 percent of Americans take loans to buy an automobile. If you are planning to buy an expensive model of a car you’re interested in, you’ll find that buying the base model or a used car instead can make repayment much easier.
You could also be looking to consolidate your credit card debt and repay it at the lower interest rate of a personal loan. A large personal loan can also be taken to handle unplanned emergency expenses, such as medical bills and funerals. Personal loans can help you when you are in a bind during an emergency.
Large personal loans for non-essential purchases, such as dream vacations, recreational vehicles, and lavish weddings, are the kind of impulses you need to stay away from. A loan is a financial commitment that you will have to pay back with interest on top, and you must exercise this option with utmost responsibility.
How much is the interest rate?
Loans come at different rates, depending on the amount of risk they pose for the lender. Typically, 30-year mortgage loans have ranged between 3%-8% for several years, mostly around the 4% mark. Personal loans, on the other hand, are usually offered around 10% at interest rates more than twice than that of mortgage loans. Your interest rate is, thus, an important financial metric. The interest rate of your loan will determine how much you will repay in installments every month. Sometimes, they may also decide how long the repayment period is.
As mentioned above, interest rates vary depending on the level of risk of the loan. Lesser risk for the lender usually translates to lower interest rates for you. With a secured loan, collateral is offered to the lender as a guarantee. The lender can take possession of the collateral if the terms of the loan are not met. Mortgages and car loans are common types of secured loans. Unsecured loans offer no such protection to the lender, as there is no collateral involved, and usually come with higher interest rates. Personal loans and student loans are common kinds of unsecured loans.
Your annual percentage rate (APR) is basically the interest rate that you will be charged for a whole year. The APR includes the interest on the loan, as well as any fees charged by the lender for making the loan. Comparing APRs on various loans is often a reliable way to gauge affordability and value offered by different lending institutions.
How fast can I pay off the loan?
How fast you can repay your loan is contingent on the repayment period of your loan. The repayment period is the term over which you repay the principal and interest on your borrowed money. A long repayment period means larger earnings for your lender and is sometimes fixed depending on the kind of loan you take.
The repayment period and your monthly installments are closely linked. The shorter the repayment period, the bigger your monthly installments become. Your aim should be to ideally keep the repayment period as short as possible. For example, you might think that a six year loan is a better option than a five year loan because of less pressure on your monthly income, but the six year loan will make you pay a lot more interest over the extra year on your principal as well.
It is difficult to build wealth for yourself if most of your income goes toward paying interest on your debt. You start working towards your financial goals when your money is creating more money for you. You must look beyond just managing to make monthly payments. You will have to focus on how to pay extra every month to pay off your loan faster.
Can I afford this loan?
Now that questions of the importance of the loan, the amount, interest and time for repayment have been considered, let’s evaluate how affordable the big loan is. A loan isn’t affordable just because you can manage to make payments every month; there are other factors to be considered also.
If you are trying to figure out if a loan is “affordable,” consider the effect the loan will have on these:
Ability to Lead Life as Usual
You must assess how meeting the monthly payment obligations will affect your life. You may find that you do not have enough savings per month to plan for things you enjoy, such as travel. You may also find that making monthly payments on your purchase squeezes out your budget so much that daily life is affected. You may no longer be able to enjoy dining out, watch movies, or go drinking with your friends because most of your income is diverted to paying for your loan.
Impact on Your Debt-to-Income Ratio
Your debt-to-income (DTI) ratio is the percentage of your monthly income that is spent paying for your debt obligations. It is calculated by dividing your total debt payments per month by your total monthly income. For example, if your monthly debt payments are $400 and your monthly income is $2,000, your DTI ratio is 20%.
Experts recommend that your debt-to-income ratio is below 36%. You might have trouble getting approved for a mortgage with a higher DTI ratio.
Total Amount Repayable (TAR)
When you are calculating how much you can afford in repayments, consider the monthly installments but also the total amount you will end up paying back.
For example, consider that you want to borrow $30,000 and the bank offers you two options:
- Option 1: $30,000 at 6% APR over 6 years (monthly installments: $497.19)
- Option 2: $30,000 at 7% APR over 3 years (monthly installments: $926.31)
The total amounts repayable at the end of the terms for Option 1 and 2 are $35,797 and $33,347 respectively. Even though the APR and monthly installments are lower with Option 1, you would end up paying $2,450 more than Option 2 over the whole term.
Are there any hidden fees involved?
It is very important to read all the terms of the loan agreement to understand your financial obligations completely. There is always more in the fine print, and loan agreements usually have hidden charges and penalties involved.
The following are some of the hidden charges that are associated with loans:
Loan Processing Fee
This is a fee charged by your lender for processing your loan application. Some lenders charge 1% of the loan amount as a processing fee. For example, a lender might charge $50 to process a $5,000 loan. Loan processing fees can be exorbitant with large home mortgages, and you should ask for them to be waived.
Late Payment Fee
Late fees can be charged by lenders for making payments that are even a day late. Besides having to make an extra payment next month, your credit score will also drop with an instance of late payment on your credit report.
Nonsufficient Funds (NSF) Fee
If a monthly payment fails because there isn’t sufficient money in your account to cover the payment or doesn’t go through for some reason, your lender can charge you a nonsufficient funds fee. It is generally around $15.
Can I pay back the loan early?
For someone trying to get out of debt quickly, the idea that you may have to pay extra to pay off your loan early can sound strange. But prepayment penalties on loans are very much a real thing. You can be charged a prepayment penalty by your lender if you pay off your loan before your term ends. In case of a home mortgage, borrowers can be charged a portion of the remaining mortgage balance or a few months’ worth of interest payments.
Though prepayment penalties can seem predatory at face value, it is usually a way for the lender to keep your business. It is possible that your loan agreement specifies that your loan is penalty-free if you are selling your home, but a prepayment penalty applies if you are looking to refinance your loan with a competing lender. A possible upside of having a prepayment clause in your loan agreement is that you may have lower interest rates because of the prepayment penalty.
Flexibility can come at a price, and sometimes, it is worth the money. If the absence of a prepayment penalty is non-negotiable for you, you might have to repay at a higher interest rate, but then you can get out of the loan anytime you have a windfall.
How credible is the lender?
There was a time when large loans were offered only by large banks with multistate branches. But as the loan services industry has grown, the number of financial institutions in the market has increased as well. You can go online and find many places that offer attractive deals on personal loans. With a plethora of competitive options comes the risk of fraudulent loan offers. As a customer, it is your right and always in your best interest to check the credibility of the company extending you a loan offer. Signs, such as the lender making an offer too good to be true or a request for upfront payment before they start providing any service are red flags that you should watch out for. Always make sure that your lender is a legitimate business and not a fly-by-night operation.
What is the disbursement time of the loan?
Disbursement time is the actual time taken by the lender to deliver funds after a loan application is made by the borrower. You may need a large loan to cover the cost of a medical emergency. You may also have to deal with unplanned emergencies like a last-minute increase in costs while building a home, the need for emergency money to keep your business running, or home repair.
At times like these, how fast your loan is sanctioned by your lender and made available to you can be critical. A loan that is disbursed too late can end up being useless for you if it is unable to perform the desired function and mitigate the feared damage in time.
What happens if I cannot pay back this loan?
A large loan is a financial commitment that can prove to be a huge liability for you if you cannot honor it. Defaulting on loan payments will tarnish your credit history and drop your credit score. According to data from FICO, a 30 day delinquency can cause a drop of 90-110 points for a borrower with a score of 780 on their FICO score. Missed payments can stay on your credit report for 24 months and make managing your personal finances difficult.
Before taking a big loan in your name, think of contingency plans. How will you deal with monthly payments if you lost your job somewhere down the line? Are you planning to save for emergency funds to keep you afloat in such a situation? Are you prepared to lose the collateral on your loan?
These are events that you must consider and plan for if you are single or the sole earner of the household before taking on a big loan.
A large loan can be expensive but beneficial if handled correctly. Taking a large loan involves thinking in terms of trade-offs: for any perceived benefit in terms of lower monthly payments and more savings, you will have to pay higher interest or assume the risk of facing penalties. It is possible that you are offered a loan that is seemingly favorable and easier to manage on a month-by-month basis but makes you pay a lot more in total than a loan with a shorter term.
“Borrow only what is essential” should be your mantra. Avoid large loans for purchases that are non-essential in nature. A shiny, red sports car with a V8 engine will look great in your garage, but high-interest payments over the years could drain your account as well. Ask yourself the 10 questions discussed above and you will find making the decision of taking on a large loan in your name easier.