When in need of extra cash to fund a big investment or handle a financial emergency, taking out a loan is one of the best options. Although some people frown upon loans and debt in general, applying for a loan is a generally wise decision because you will be able to manage a revolving fund without drying out your bank account!
But before going to the nearest lender to begin the application process, you must make sure that you are ready to take out a loan. Here are some things to consider.
Why do you need a loan?
The first thing you must think about is the type of loan you need. Ask yourself, why do I need to take out a loan? Is it a necessity? There are various loan types available, be it a home loan, student loan, or car loan. It is generally recommended to take out a personal loan for a smaller amount to be paid over a shorter period. But for larger purchases, you would want to select the type of loan that best suits your requirements.
How much do you need?
Once you have decided on the type of loan, you must then calculate how much money you need to borrow. Take into account all the associated costs and fees, and only borrow what is absolutely necessary. You don’t want to be taking out a loan that you will have difficulty repaying, even if the amount of money seems highly attractive at the time.
How long will you be paying for the loan?
The next thing to consider is the repayment period, which is the amount of time you have to repay the loan. This period is usually determined by the lender, but this is a great time to use your negotiating skills as well! You can try to arrange for a longer or shorter period, depending on your financial requirements and capabilities.
Negotiating comes with its pros and cons. Longer periods usually have higher interest rates, but give you a bit more breathing room to pay back the loan. And while shorter periods offer lower interest rates, you may be pressed for time to settle the full amount.
Additionally, keep in mind that the repayment period is often broken down into monthly payments. So, it isn’t just a matter of whether you can afford to repay the full loan amount plus interest. You must make sure that you are capable to meet your monthly payments to avoid penalties and negatively impacting your credit score.
Do you have a good credit score?
Another important factor to consider is your credit score. This number gives lenders an idea of how likely you are to repay a loan. Additionally, it is one of the main reasons why your loan application can get denied!
If your credit score is low, you may be less likely to get approved for a loan or you may end up with a higher interest rate. Note, however, that credit scores will depend on where you are located.
What is the interest rate? Are there any other fees?
Interest is one of the biggest costs of taking out a loan. As previously mentioned, interest rates can vary depending on the repayment period of your loan. In addition, financial institutions and lenders also have varying rates, so it is best to shop around first before signing a loan agreement.
Aside from the interest rate, loans also have additional fees that you may not be aware of. Before agreeing to the terms of the loan, ask the lender about other fees such as an application fee, origination fee, and pre-payment or late payment penalties.
What does your current financial situation look like?
Once you know all the details of the loan you want to take out, it’s time to sign the necessary paperwork, right? Well, not quite yet. There is one more thing you need to do, which is arguably the most important thing – make a detailed assessment of your financial situation.
First, revisit your ability to make the monthly loan payments. In this step, it’s a good idea to list down your sources of funds. Will it be coming from your monthly income? Pension? Savings? A good credit score may help you secure a loan, but if you don’t construct a plan on how to make the payments, your credit score can easily take a plunge.
Second, take a close look at your liquidity. If you plan on repaying your loan by using a steady stream of income, what happens if the income abruptly stops? Say, for example, you lose your job all of a sudden. How will you be making your loan payments?
It is important to check your liquidity, meaning your ability to access cash when you need it, to make sure that you will still be able to repay your loan despite any unforeseen circumstances.
Lastly, consider your debt-to-income ratio (DTI). This is a good metric to use to get an idea of how much financial stress you can handle. This ratio refers to the amount of debt you have relative to your income. Aside from the loan that you are taking out, do you have any other financial obligations that you have yet to pay off? A high DTI means that you have a higher chance of defaulting on your loan, and lenders will often look at this metric before approving the terms of the loan.
Taking out a loan can be a helpful way to get through a financial crisis, or fund big purchases in pursuit of your dreams. But before you do so, be sure to keep these things in mind so you can make sure that you’re taking out a loan for the right reasons.