Why People Get Loans

If there’s something that you want to buy, that you don’t have the money for at the present time, there’s two ways that you can get it. You can save up for it, setting aside a certain amount of money over a period of intervals, until you have enough to buy it.

The other way to get it is to borrow the money, and instead of setting the amount aside in savings, you instead make payments on the borrowed money.

Why People Get LoansWhen you save up for something, you collect interest on the money while it is being saved, and if you borrow the money with a loan, you instead pay interest to the loan grantor.

With this being the case, it may seem that the best way to get something is to save for it and never borrow unless you really have to, but that’s not necessarily the case. There are several reasons why people may want to borrow instead, and one of them is certainly the ability to enjoy the purchase right away instead of having to wait a certain amount of time, often a fairly long time.

Neither approach, either saving or borrowing, should be taken without enough proper thought into what may be best in a given circumstance, although there are plenty of people who either just decide that they are going to save or decide to borrow without really considering whether they are making the best choice overall for themselves.

That’s not the ideal way to decide matters of personal finance though, and there are indeed several things to account for in looking to decide which decision is best.

Having A Good Plan to Pay Back the Loan

The first thing to look at in seeking to decide whether one should get a loan is of course whether or not one would qualify for the loan, and if so, what terms one may be exposed to in doing so.

If you have bad credit or insufficient income to support the payments on the loan, then this is going to influence things a lot, as it should. In almost all cases, there’s a loan out there for everyone, provided that they do have the income to support the repayment of it.

While credit card companies often overextend credit to people, increasing one’s borrowing limits with little or no regard to income or debt ratios, this is far less the case with loans. Even a payday loan will require you to prove that you have the income to support the repayment of it, and since the terms of these loans are very short, to be repaid in full upon the next pay check, they still need to ensure that the borrower has enough capacity to repay the loan.

The biggest problem with these loans isn’t even the extremely high interest rates, it’s the fact that by repaying the loan, this usually leaves the borrower in a bad predicament. Repayment takes a significant chunk of one’s next pay, and when people have to get by on half their normal pay, this will usually require taking out another loan for the next pay period, and the total interest paid back over the life of the series of payday loans can be several times the original principal amount if one does not default.

This is a case where one cannot afford to borrow, and to make sense of these loans, one would need to have a clear exit strategy that did not involve taking out multiple loans because one cannot afford the loan, or be even close to doing so.

If one was expecting some extra money at the end of the cycle, and really needed something that couldn’t wait, the basic essentials of life such as paying the rent or buying food, or making a payment on another loan where not doing so may wreck one’s credit, then these very high interest loans can make sense. This is not how they are used though typically.

If you cannot pay the rent this month, and you get a payday loan to pay it, and you don’t have a plan to extricate yourself from the loan, you won’t be able to both pay the loan back and pay the rent next time. So, we don’t want to throw good money after bad and no matter what the circumstances, if getting a loan will just delay the inevitable, this will just end up causing people further grief.

The same principle applies to looking to take out any loan, as we need to ensure that we have the reasonable capacity to pay it back. As a good rule of thumb, if you can’t save for it, you certainly can’t borrow for it.

The ability to pay it back does factor significantly in the decision to lend to you, but this is something that borrowers also need to give careful thought to.

The Time Value of Money

With some people, those with less discipline, they may not be able to save where they could reasonably borrow, if the problem is not being able to allocate the funds to what is sought to be purchased due to the money being spent on less desirable items. You may want and need a better car for instance, but you might end up not being able to save for it due to buying stuff you need less.

Some people feel a need to spend all the money they make, and then some, and if you have a few extra bucks lying around, instead of saving it, you might spend it on even the most frivolous purchases. These less valuable purchases can be more appealing though than more valuable ones that you have to wait to purchase.

This is due to the time value of money, and a dollar in the hand is sometimes seen to be worth two dollars in the bush, so to speak. It is natural actually to discount money over time, and future money will be worth less to some degree, although with some people it is worth considerably less.

This is where loans come in, to bridge the gap. If you have to save up for something, assuming you have the capacity to do so, which is an absolute requirement by the way, there’s going to be a certain risk that you may not follow through with your plan.

Not following through may be for good or not so good reasons. Losing your job for instance is a good reason, and in fact in this case, choosing to save is often the better choice. Not being able to continue saving for something is generally preferable to not being able to make loan payments.

Less good reasons would be that you decide to blow the money on something else at some point, where the wiser decision would be to continue to save for the intended future purchase. Getting a loan eliminates the chances for this, as you are then more committed to devoting the required amount of money each period to make payments on the loan.

Having it Now Is Sometimes the Better Choice Overall

So, the benefits of the loan are both having the ability to enjoy the purchase now, being able to drive the better car for instance, and the loan making it easier to stay the course. Some people are more prone to mistakes here than others, and sometimes need to be forced into making better decisions, which loans generally serve to do.

The level of need or satisfaction is also going to factor into the decision to borrow or not quite a bit. In the case of getting another car, you might not have a car now and may need one, or you might be driving an older car which will cost more to fix than it’s worth.

You may also not need the better car, and may be doing so simply because you desire better, which is fine, but we must decide whether the additional cost of paying interest on a loan is going to be worth it for us.

Many people consume rather mindlessly, as we’ve been trained to do by the enormous amount of advertising we are exposed to, and it always pays to carefully consider all of your buying decisions, and not just react like one of Pavlov’s dogs, where the bell rings and we then start to salivate. Given that the bell is continually ringing, this may not be the most financially healthy way to conduct your buying decisions.

On the other side of the coin, there are many who look down upon people getting loans to buy things, and paint all of this rather darkly. This is not the right approach either, as there may and often are some very good reasons to get a loan to buy something, and we don’t want to exclude these benefits due to an overly polarized and narrow view of borrowing.

Loans are essentially investments, where the return is the purchase now rather than later, and the cost is the interest paid on the loan required to get it. While we normally think of investments as producing monetary returns, these investments produce satisfaction, but they are still investments. We need to make sure we get enough return on them to justify the additional cost of jumping the queue and enjoying it now.

This does require considerably more thinking than a lot of people tend to devote to borrowing decisions, but it’s time well spent, given the significance of the investment.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: [email protected]

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