It’s important for you to be well informed about various issues that can affect your money. When it comes to your finances, ignorance can be very expensive. Borrowing money comes with a cost, and there are many considerations that you need to think about before you take on debt.

Why do you want to borrow?

Prior to making any borrowing decisions, you need to be honest about the reasons why you think you need a loan in the first place. Do you choose to buy consumer items on credit just because you want to get them right away, or are you using loans to help you meet your monthly bills?

It’s best to avoid borrowing to satisfy immediate gratification desires or support budget shortfalls. In the first case, you will make unnecessary interest payments because you lacked the discipline to save for what you want, while the second reason will throw you into a never-ending cycle of debt.

Borrowing can be useful if it will lead to some future benefit, or if the interest costs can be covered by your plans. So if you borrow to buy property, your loan payments will eventually be justified by the increased value, while business loan charges can be paid from operational revenue.

Can you afford to borrow?

Even if you want to borrow for a productive purpose, you need to ensure that you can comfortably make the periodic payments. Doing a detailed budget is essential in order to determine if you can afford the cost of a loan, as it will indicate the effects of the new expense on your other bills.

Find out the estimated repayment figure for the loan and add this figure into your monthly spending plan. If you didn’t have any excess money in your budget to meet this added cost, how will you pay for the loan? Are you able to cut back on other bills to allow you to make this new payment?

Another consideration is the consistency of your income stream. Resist taking out loans if you earn part-time income or if you receive varying commission amounts which may not necessarily cover the monthly payment. Also, do not depend on expected future income which may be uncertain.

How is the loan interest calculated?

Your loan payment is only one factor; you also need to be aware of all the costs of borrowing. Some of the questions you need to ask are: What is the annualised interest rate? What is the commitment fee? Are there penalties for late or early repayments? Are insurance premiums added into the loan?

The method of calculating interest can make a big difference to the total amount you end up paying. Reducing balance loans calculate interest on your principal balance after each payment is made. Other loans work out the total interest over the term, and divide this cost into equal payments.

Some loan agreements may require you to pay all the expected interest, even if you pay it off early. Also, some options may not allow you to make ad hoc lump sum payments to the principal outside of the anniversary date, or without renegotiating the entire agreement. Find out before you borrow!

What are the terms of the loan contract?

Taking out a loan is a contractual agreement, and you need to be very clear about your obligations before you sign on the dotted line. It is risky to affix your signature to a loan document without understanding the details of the contract, as the terms can be potentially harmful to your finances.

Many loan contracts are written in archaic language and are loaded with legal jargon which might be difficult for the average person to read. Ask the loan officer to explain what each paragraph entails, and don’t be embarrassed if it takes you a while to comprehend everything.

It’s also crucial to get a copy of every document you sign or any written communication pertaining to the loan. Even if you are not clear about all the details, you will have a record of your agreement that someone else can clarify, especially if there is some dispute about the loan in the future.

Are there other options apart from borrowing?

Very often, many persons opt to take out a loan as their first choice when they need to pay bills, acquire something or start a business. It’s difficult to resist borrowing as all the financial institutions promote their convenient loan plans and encourage you not to wait for what you want.

Remember that when you pay interest on a loan, this money represents funds that could have been used to build your own wealth. Before you make the decision to borrow, consider whether there are any other routes to achieving your objectives without incurring debt.

Can you save up and pay cash instead? Can you start out small with money you have on hand and build up over time? Can you get someone to partner with you in your business? Can you increase your earnings to pay for your acquisition? Think of all your options before you commit to borrowing.

Copyright © 2014 Cherryl Hanson Simpson. No reproduction without written consent.

Originally published in The Daily Observer, February 20, 2014

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Cherryl is a money coach and business mentor, and founder of Financially S.M.A.R.T. Services. See more of her work at www.entrepreneursinjamaica.com and www.financiallysmart.org. Contact Cherryl