Under what circumstances is taking a loan from a bank a financially wise thing to do? The golden rule is this: The thing that you are taking a loan to pay for should increase your financial well-being over time. Let’s look at a few examples.
Personal Loan for Education
Should you borrow to finance your university or post-graduate studies? The answer to this is almost always “yes” as it would enable you to increase your earning power for the rest of your working life. You are likely to make back much more than what you would spend on a higher education plus interest costs. However, if your further education is a degree in horse-back riding and you are doing it purely out of interest rather than to make a career out of it, then it wouldn’t be wise to take out a large loan for it. You wouldn’t be abiding by the golden rule.
For most people, their home is the single largest financial transaction they will make in their lives, so taking up a Home Loan is almost always necessary. The thing to note here is that you should not treat your home as an investment, but as a consumption item. This is because even if your home increases in value, you can’t sell it to realise your profit because you need a place to stay and any equivalent home would cost as much. You might think that you can downgrade to a smaller home, but in reality, downgrading is very difficult for most people as they would have gotten used to a certain lifestyle.
Treating your home as a consumption item means that you should live within, or below, your means. Do not buy a property that would stretch your ability to service the loan to the limit. If you do that, you might find that unexpected events, such as an illness or retrenchment, might ruin you financially, when you have a non-existent or insufficient buffer of cash to tide you over.
If you are buying a second property for investment and you need to take a loan, you have to do your sums right. After a robust, level-headed analysis (i.e., you are not doing it just because everyone seems to be doing it), and you are confident that your rental return and your expected increase in property value over time would exceed the expenses you have to incur in maintaining the property and the amount you would pay in interest costs, plus you are comfortable in taking a hit in case you cannot find a tenant for an extended period of time, then taking a loan would make sense.
Personal Loan for Holiday
You would think of all the best reasons in the world why you should borrow to go on a holiday, because you really, reallywant to, but it is a bad idea financially. The loan would likely be a Personal Loan as it is not an asset-backed loan like a house, and the interest rate is likely to be high. This would be a yoke that would burden you long after the photos on your holiday have faded.
You can make many intelligent arguments for why you should go (e.g. “If I don’t, I won’t get another chance for a long time”, “it will make me feel better and I will be more productive”), but it would not change the reality that it does not make good financial sense. For all consumption items (e.g., handbags, big-screen TVs), you should have the money on-hand before you buy them. The only exception to this golden rule is using a credit card (yes, it’s a form of short-term loan or credit) to pay, in order to earn the reward points or cashback. Even then, make sure you can pay off your statement in full the next month, as the ~18% p.a. interest rate for credit cards is even higher than that of personal loans.
Apply the golden rule. If you are in sales and you need a car to make a living, it makes sense. If your needs for a car are mainly leisure in nature, you should consider transport options where you can have access to a car only when you need it, such as the various car-sharing schemes or Uber and GrabCar.
This example is to showcase how to think using the golden rule. If you say you want to take a loan for a cosmetic surgical procedure that would make you look better, and you feel that you would be able to make more money in the long run as a result of it, you might not be wrong. Many studies do show that better-looking people make more money.
If you are savvy stock investor who has been making money investing in the stock market, you would know how to do your sums and whether to borrow. If you are even asking the question of whether you should borrow for stock investments, you are likely not to be a savvy investor and you are just hoping that you can make a quick killing on the stock market with borrowed money. If that’s the case, do not do it!
If your business is already running and generating cash-flow, you can talk to your banker about a loan if you need it to grow your business. If you just have an idea, no bank will lend you money for it, so the only option open to you might be a personal loan at high interest. This is no way to fund a start-up. Don’t think that all businesses would be like Facebook in the movie The Social Network. 99.99% of businesses take a very long time to succeed. If you have a high-interest loan to worry about, you’d be very stressed about money and won’t be able to focus on the business. You should try to raise money by attracting investors instead.
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