The Dangers Of Borrowing Money

2014-11-21

Bradley Milne

Borrowing money is something almost all of us must do at one time or another. Just because you’re borrowing money, doesn’t mean you shouldn’t be smart about it. Being an educated borrower means understanding and following some basic guidelines

  • Develop and follow an affordable budget. In doing so, you will have a greater understanding of your ability to service debt.
  • Take your time when borrowing money. Shop around and make sure that you are getting a competitive and reasonable interest rate.
  • Read and understand the documents you are signing. All too often, people sign an agreement to obtain credit without understanding the actual cost of borrowing, application of service fees and other related charges.
  • Understand what it means to give your property as security on a loan and the repercussions of failing to honour your financial obligation. There are many situations in which people borrow money and are not even aware they have pledged their personal property as collateral on the loan. 

Borrowing wisely also means knowing the potential challenges you face when accessing certain forms of credit.

Credit Cards

Using credit cards responsibly, either by paying the balance in full when the payment is due or as soon as you can afford within the prescribed due dates, can keep finance charges to a minimum and help you gain access to longer-term credit (e.g. mortgages, car loans).

While credit cards are necessary for many transactions (e.g. booking a hotel room), generally speaking it is always better to use cash when shopping. One of the dangers associated with using credit cards is they can lead to impulse spending, without any thought as to how the funds may be repaid later on. With interest charges in the range of 15% to 20% or more, the amount owing on a credit card can escalate rapidly. If your monthly budget only allows you to make the minimum payment, you may end up “servicing the interest” for a long period of time without making any meaningful progress in paying down the principle balance.

You should always limit the number of credit cards you maintain. In addition, there is nothing wrong with setting a personal limit on your credit card rather than accepting ongoing, automatic limit increases your credit card company may grant you that could lead to financial troubles later on.

As a final note, be wary of retail credit cards that can only be used at one particular store and tend to have higher interest rates than many other credit cards.

Lines of Credit

While lines of credit typically have lower interest rates than most credit cards, many financial experts believe this form of borrowing can be more dangerous. Any payments made on a line of credit simply results in that amount of credit becoming available again, whereas with a personal loan, you would be one step / payment closer to completing your financial obligation.  As with credit cards, there is a greater risk of the balance escalating to the point where minimum payments only service the interest.

If your line of credit is being used for home repairs or renovations, understand that the financial institution advancing the credit may require your home as collateral, similar to a second mortgage.

Consolidation Loans

If your credit has not been tarnished by missed payments and collection actions, you may be able to consolidate your debt into a single loan with one monthly payment at a low rate of interest compared to your credit cards and / or other debts. If your credit rating is poor, you may require a co-signor or guarantor, which is not always possible or desirable. Alternatively, if you have equity in an asset (such as your home), you may be required to offer the asset as collateral against the loan.

If you have equity in your home, you might consider refinancing your mortgage and using the funds to pay off your unsecured debt, starting with the highest interest rate liabilities. A mortgage generally offers interest rates that are considerably lower than most other forms of debt.

Second Mortgages

A second mortgage may be a viable option for consolidating existing debt, provided you are able to obtain a reasonable interest rate and payment terms that suit your monthly budget. However, in my experience, most second mortgages tend to be obtained through high risk lenders with high interest rates and payment terms that cannot realistically be fulfilled in the long-term. The end result is a situation where you may not achieve true financial relief and instead, substitute one bad situation with another. Only now, you have taken on more risk by providing your home as collateral on debt that was previously unsecured.

Payday Loans

A payday loan is a short-term loan that you must typically pay back with your next paycheque.  The dangers associated with such loans are well-documented, particularly their high interest rates and related service charges. A significant portion of your next paycheque is required to pay the loan, resulting in the necessity of obtaining another loan, which in turn leads to an endless cycle of borrowing that is very difficult to stop. You may repay several loans over time, none of which will likely enhance your credit rating. However, if you fall victim to the high interest and service charges and fail to repay the loan in a timely fashion, you are likely to be subject to collection action and your credit rating will be a negatively impacted.

Borrowing from Family

Borrowing money from family can lead to many pitfalls. It may cause you to feel inferior and / or create tension in a relationship, particularly if you are unable to repay the funds in the agreed-upon timeframe. If you do make your payments on schedule, there is no record of it and therefore it does not improve your credit rating.

For more information about the Dangers of Borrowing Money, please contact a MNP LTD Trustee - we're here to help!