How to borrow money responsibly
A 6 minute read • Simon Q
Part of our financial management series. Here at NobodyToldUs.com we don’t give financial advice, but we do offer some tips that you can consider when deciding how best to manage your money.
Why do we need to borrow money?
We usually borrow money to pay for things we can’t afford to buy outright in a single transaction such as a car or house. We can spread the payments over a number of years as long as we’re comfortable paying a premium for the convenience.
We also borrow money to help us get through periods when either we have reduced money coming in or temporarily high outgoings.
“The key lies in understanding the options”
But the key to borrowing money responsibly lies in understanding the options available to you, the commitment you will be making and the caveats that may accompany the choices you make. And if you already manage a home budget then you are in a good place to decide whether or not you need to borrow or how best to borrow money for that special (or unexpected) event.
Remember that one option is to use your savings, if you have any. Interest rates remain low so using your savings of say £5,000/~$7,000 to pay for something may be considerably more cost effective than taking out a loan for this amount and paying the associated interest.
What’s the difference between a secured and an unsecured loan?
If you choose to buy a property, the mortgage you take out will be a secured loan. Also known as a secured debt, a secured loan ties the borrowing to your assets, such as the property. Effectively you agree that your possessions will be collateral for the loan. So if you default on the loan, the lender has the right to ‘extract’ what it is owed from your assets and could decide to sell your property in order to do so.
If it sounds risky, then that’s because it can be, especially when you don’t have a stable income. The flip side is that a secured loan generally attracts a lower interest rate than an unsecured loan. It’s also the most common and cost-effective way to buy a property.
Aside from a mortgage, most of the loans we take out are unsecured. In other words the repercussions for defaulting on the loan are usually less drastic although can be costly. Unsecured loans attract higher interest rates as a way for the lender to manage their risk and discourage irresponsible borrowing.
Expensive ways to borrow money
It probably seems obvious that the most expensive way to borrow money is through an unsecured loan. But it depends on how long it will take for you to pay it back. If you borrow an amount of money for a short period of time, say a few weeks, at a high interest rate then the total cost of the loan may be acceptable to you and get you out of a fix. Examples of this type of borrowing are:
- Payday loans – sometimes called cash advance loans
- Interest on a credit card balance that you don’t settle at the end of the month
- An unarranged overdraft on your current or checking account
Payday loans in particular attract high interest rates with an Annual Percentage Rate (APR) that can be thousands of percent. But if you consider that paying a charge of £25/~$35 to borrow £200/~$300 for 14 days is acceptable then you may deem the APR to be irrelevant. But if you don’t pay back your loan after 14 days, you will quickly ramp up charges that may ultimately exceed the initial amount you borrowed within a short time.
Annual Percentage Rate (APR)
The interest and charges for a full year of borrowing expressed as a percentage and intended for comparison purposes
Interest on the balance owed to your credit card company can be small and acceptable if you use the card to buy something you know you can pay off in a couple of months. But again, like payday loans, this is only a short-term solution and the cost of longer-term borrowing on credit cards can be crippling. This happens because you keep adding to the debt each month and pay interest on the interest and debt you owe, something called compound interest.
Similarly, going into the red on your current account without the approval of your bank can be extremely expensive. Many banks will add daily charges as well as interest for the period that your balance is in the red so it’s probably best avoided.
More cost-effective ways to borrow money
Thankfully, there are other ways to borrow money. A mortgage will allow you to buy a property at a reasonable interest rate and your bank will consider you for an unsecured loan if you have managed your accounts with them well. You can also sometimes arrange an additional secured loan against your property from your mortgage lender.
Arranging a loan through your bank is usually easy and quick. You can also shop around other banks to find a good deal by comparing APRs for loans with similar terms. Comparison websites are useful too.
But let’s pretend that you have ‘maxed out on your credit cards’, owe £10,000/~$14,000 and are paying an APR of say 25%. It’s tempting to get a bank loan for that amount at an APR of say 5% and pay off the credit card outright, you can pay back the bank loan over a manageable period of time at the lower interest rate. Although this may make sense, you will need enormous self discipline to avoid building up a debt on your credit cards again.
“You will need self discipline”
Remember that you can also borrow money from friends and family. While this may not be acceptable to some people, it’s a reasonable request to make if you are in a fix and you may be surprised how keen they are to help. You can offer a small amount of interest as a ‘thank you’.
But take care if you do borrow from friends or family as some people fall out over money. If you take this route, consider writing and signing an agreement between yourself and the lender covering the terms of the loan, including the total, any interest and the date by which it will be paid off. This may sound a little formal but protects both parties from disagreement.
If you can’t pay back your loan
You have your loan, have been paying it back for a while now but are struggling financially. You’re about to miss a payment or cannot pay back anything more on your credit card than the monthly minimum.
First, don’t make any rash decisions as there’s help out there for free. In the UK, for example, the Money Advice Service1 has plenty of advice that will help you take control of debt. And there are debt advisors who provide free services to help you plan to clear your debts. As your debt will be specific to you, it’s best to consult an expert before making any decisions.
“As your debt will be specific to you, consult an expert before making decisions”
The key to managing debt is to know what you owe and to whom and then develop a plan that gives priority to paying off debts that could lead to legal action, bankruptcy, or other severe consequences. Note that these priority debts don’t necessarily include unsecured loans but do include mortgages, income and local tax, gas and electricity bills and court fines. As you can see, some debts are more important than others.
Here are a few things you could consider (and discuss with an advisor) if you get into a fix:
- Make sure you know what you owe – keep a record of what you borrowed, how much you have paid off and what you still owe
- Pay your priority debts to avoid legal action
- Speak to your lender to ask if they will give you a ‘payment holiday’ to take the pressure off; of course you’ll have to pay back the missed installment later
- Avoid missing a payment on a loan if you can
- Seek other ways to borrow at a lower rate – for example some credit card companies allow you to transfer your debt to one of their 0% APR cards
- Explore if consolidating your debts into a single low cost loan is possible; this may be an effective way to manage your credit card debt
Remember that if you come into money while you have a loan, paying off the loan can be a good idea. I once won a workplace lottery and used the winnings to pay off a car loan rather than take an extravagant holiday. Knowing the loan was gone felt as good as a week in the sun.
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References 1Money Advice Service
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