Borrowing money can be a useful tool for achieving major life goals like pursuing higher education, purchasing a home, or buying a car. However, with various borrowing options available, each with its own pros and cons, it’s crucial to approach the process with careful consideration. So, this article highlights some of the most common mistakes individuals make when borrowing money and offers tips on how to avoid them.
Underestimating the Total Cost of Borrowing
Interest is just the beginning of the additional costs of borrowing. Loan terms and insurance must also be factored in when calculating the total cost of a loan. Underestimating the total cost of a loan can lead to more borrowing and potential debt spirals.
Not Reading Customer Reviews of Lenders
Customer reviews provide useful insight into a lender’s customer service, flexibility, and reliability. Borrowers should avoid lenders with a pattern of negative reviews and instead consider lenders with more positive feedback.
Overlooking Insurance and Protection Plans
Loan protection options, including payment protection insurance, cover debt payments if the borrower is unable to pay due to a covered event, such as illness, unemployment, or disability. They can be a worthwhile choice if they are inexpensive and provide suitable coverage, but they do not lower loan interest rates.
Ignoring the Impact on Personal Relationships
Borrowing from friends and family can be a great alternative to bank loans, but can strain relationships. The loan terms should be formalized to prevent misunderstandings and harsh interest rates.
Borrowing More Than Needed
Lenders will often offer larger loans than what borrowers initially requested. Locklin Capital notes that lenders receive bigger compensations for bigger loans, so they are less likely to offer smaller loans. Borrowing more than necessary can be problematic, leading to prolonged debt and increased interest costs.
Failing to Explore Debt Consolidation
Consolidating multiple debts into a single loan is a good option for borrowers looking to simplify payments and potentially lower interest rates. However, it may not be a good idea if the borrower’s current monthly payments and rates are lower than the consolidated option and if their debt load is more than half their income.
Not Considering the Loan’s Impact on Future Finances
Borrowers should consider how a loan fits into their broader financial plans, like saving for retirement or buying a home. They should also consider the impact of taking out a loan on their debt-to-income ratio, as taking on too much debt could jeopardize their financial stability.
Relying Solely on Unsecured Loans
In secured debts, a borrower puts up an asset as collateral for the loan, while unsecured loans have no collateral backing. Unsecured loans, on the other hand, are issued based on the borrower’s creditworthiness and have strict debt-to-income requirements, so they are unsuitable for those with lower credit scores and incomes.
Neglecting Credit Score Improvement
Finra explains that credit scores are used by lenders “to help them decide whether you get a mortgage, a credit card, or some other line of credit, and the interest rate you are charged for this credit.” Better credit scores get better loan terms, so those looking to borrow money should research and implement methods to improve their credit scores.
Disregarding the Purpose of the Loan
Borrowing should be purposeful, with a clear and justifiable reason for taking out a loan. Luxury purchases, holiday homes, and other unnecessary expenditures aren’t good reasons to take out a loan. They’re not worth the risk.
Not Planning for Interest Rate Fluctuations
Fixed-interest-rate loans are not subject to interest rate fluctuations and remain the same for the life of the loan. Variable-interest-rate loans are subject to market fluctuations, so borrowers with this kind of loan can find themselves paying much higher interest when interest rates rise, more than they would have with a fixed interest rate.
Not Having a Repayment Plan
Experian explains that “a repayment plan is an agreement between a borrower and a lender for how a debt will be paid off over time” and that they often refer to special agreements for borrowers struggling to pay. Repayment plans are useful terms for having a clear budget and structured plan to repay a loan.
Not Shopping Around for Better Rates
Many borrowers accept the first loan offer they receive without comparing it with rates from different lenders. Lower interest rates can significantly reduce overall borrowing costs, and websites like NerdWallet and Bankrate can compare and reveal the best loan offers for borrowers.
Overlooking the Fine Print
Loans often include hidden charges like origination fees, prepayment penalties, and late payment fees. Investopedia argues that “it’s important to review loan terms carefully to check for any hidden clauses or fees that could potentially cost you money” and that Americans should educate themselves about different loan terms.
Failing to Consider Other Financing Options
There are plenty of alternatives to bank loans available to borrowers. Peer-to-peer lending, family loans, and credit loans can be preferred alternatives, but they each have downsides. Peer-to-peer lending, for example, can offer lower interest rates but have much higher default rates.
Ignoring Loan Repayment Terms
There are several repayment plans available to borrowers, including fixed interest, variable interest, and balloon payments. It’s essential to research each loan repayment plan to ensure it fits with the borrower’s financial situation, as there are serious consequences for failing to meet loan repayment obligations.
Skipping Financial Advice
Consulting with an independent financial advisor before taking out a large loan is important, as an expert opinion will help to avoid impulsive, overly risky decisions. Professional advice is particularly valuable when considering debt consolidation or financing significant investments.
Ignoring Alternative Repayment Strategies
There are alternatives other than monthly repayments for most loans. More frequent payments or larger bulk payments can be useful options. Some loans, like student loans, have loan forgiveness plans for those struggling to make the monthly payments.