Important factors to consider before borrowing
Credit is a tool, just like a hammer is a tool. These tools are neither good nor bad. They can help you in achieving objectives if used properly. However, there may be negative consequences if credit is not used responsibly.
In this section you will learn about some of the important factors that you, as a potential borrower, should consider so that you can use credit as an effective tool. One of the most important factors to consider is the cost of borrowing money.
Cost of borrowing
The two main components to consider when determining the cost of borrowing money are the principal amount and the interest.
Principal amount is the original amount borrowed or the amount that remains unpaid.
Interest is the additional amount owed to the lender based on the outstanding balance.
Borrowing money allows you to get what you want today, but at an additional cost. When borrowing money, people are able to make a purchase today by “renting” someone else’s money. The expense of renting this borrowed money is called interest. An important question to ask is whether the cost (interest) of borrowing someone else’s money is worth the benefit of making the purchase today instead of at a later date.
If you make a purchase now using a loan, then this will cost you the purchase price plus interest. However, if you make the same purchase at a later date using your savings, then you will only have to pay the purchase price. Therefore, the overall purchase will cost you less if you make the purchase with your savings at a later date.
For example, financing a $20,000 car could cost approximately $4,000 in interest only. This means the total cost of the $20,000 car would be $24,000. (8% interest, 5 year amortization.)
Comparing the costs of borrowing of different types of credit products
Let’s assume that you have made the decision to purchase something now and pay the additional borrowing cost. Interest often makes up a large part of the total purchase cost.
The challenge is that there are various ways to calculate interest and the cost of borrowing can vary significantly depending on the method used. The annual percentage rate (APR) is designed to provide a common measure for comparing the interest rates of different loan products.
The APR is a standard way of expressing the interest. It can help you compare rates from one loan to another because it's calculated using standardized rules.
For example, suppose your oven breaks down and you need to buy a new one. The new oven costs $1,000 at your local department store. You are considering different options, including a credit card, a store credit card, a line of credit from your bank, a rent-to-own contract, or using your emergency fund.
Comparing different financing methods
The best option is almost always to use your savings to pay for an unexpected expense such as this one. If you don’t have enough savings to cover the cost of the oven, then the next best option in this case is to pay for it using a line of credit. However, it's important to note that a line of credit is not always the least expensive loan option. There are many situations in which other types of credit might actually be less expensive and/or less risky than a line of credit. You should always explore options specific to your situation. Above all, consider all of the factors, such as what the total cost of the purchase will be.
Ask the lender about the fees and interest you will pay before you sign a loan agreement.
To understand the cost of a loan, make sure that you ask:
- What is the total cost of the loan including interest? This will help you determine whether buying now versus later is worth the additional borrowing cost.
- What is the APR on the loan? This will help you choose between various borrowing options.
Remember that there may be other fees, charges and conditions associated with borrowing money, on top of the interest. Before deciding to borrow, make sure you understand all of the terms and conditions of the loan.
If you have questions, write them down and bring them to your in-person counselling session.
Payday loans
Payday loans are short-term loans, approximately 14 days in length. A payday loan is typically a small-dollar loan of up to $1,500. These loans are offered by a non-traditional financial service provider.
The cost of a payday loan is typically based on a set dollar amount per $100 borrowed. For instance, let’s assume that a $100 payday loans costs approximately $18. If someone borrows $100 from a payday loan and repays it in 2 weeks, this borrower will need to pay $18 on the $100. If the borrower continues to do this for an entire year, that is 26 payday loans. The original $100 loan will cost $468, and therefore the APR of this payday loan is 468%. Also, borrowers who are unable to repay their loans in full and on time may have to pay additional fees. When comparing the APR of payday loans to the APR of the financing products listed in the infographic above, payday loans are generally the most expensive financing option.
Consider your other options before resorting to payday loans:
- use your emergency savings fund
- negotiate with your creditors and discuss alternate payment arrangements
- get a loan from your family or friends
- cash in your vacation days at work
- ask your employer for a pay advance
- obtain a line of credit
Be aware of payday loans. Payday loans typically have very high interest rates and charge costly fees so it's important that you understand all of the loan terms. Payday loan interest rates and fees vary by province. Before taking a payday loan, consider all other options.
Auto financing
Auto financing is another type of credit that many people need to consider. Buying a car is typically the second biggest purchase after a house and it often requires borrowing money.
The length of the loan and the amount of the payments are other important factors to consider when borrowing money to buy a car. These considerations are particularly important when buying something that will go down in value, such as an automobile.
If you have questions, write them down and bring them to your in-person counselling session.