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What to ask yourself before taking on (more) debt
Always ask what the true cost of borrowing is before taking on debt. When a client borrows money, he incurs both financial costs and transaction costs. Financial costs include: interest, loan or membership fees, and savings requirements. Transaction costs refer to either money paid out or opportunity costs to access the loan. Examples of transaction costs are transportation or child care costs while attending meetings. Other transaction costs are indirect costs imposed by lenders through their delivery systems, but which are not received by the lending organization in the form of revenue. For example, if a client is required to open a bank account to receive a loan, she incurs the cost of maintaining that account. Another cost included in the true cost of borrowing is opportunity cost. Opportunity cost refers to lost income because the money isn’t available to be used elsewhere, but it also refers to time expended.
Some other questions that we suggest are:
Is this a planned purchase, and if not, is it an emergency?
Who benefits the most from me taking on the debt — the lender or me?
Will borrowing money lead to any potential tax savings, such as an RRSP deduction?
Is a portion of the interest tax deductible? What is the likelihood of the purchase appreciating in value or resulting in an increase to my net worth?
Will the yield and potential return of my investment outweigh the cost of borrowing?
Is the interest rate the lowest available, and have I compared all my options?
Do I have a means of paying it off over time without getting further in debt?
Have I exhausted all other ways of finding money? Can I cash something in? Or rent out part of my house? Or get a part-time job? Can I borrow from family and friends?
Here are a few things most financial advisers agree on:
- Negotiate flexible repayment terms when you get the loan that allow you to pay off the whole sum if you come into some extra cash.
- Regardless of what you pay off first, make sure you're making all your regular payments on your other debts.
- Consolidate your debts so that you reduce your interest to the lowest rate and have only one monthly payment to make.
- Pay attention to the principal — not just the interest and the minimum payment.
- Make a plan for how you will repay the loan and by what date, with concrete steps for how you will cut back your budget and raise the money you need and stick to it!
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