Angela K. Love
Personal + Business Finance Consultant

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Loans - Should We or Shouldn't We?

Loans are like power tools, they can help you build really cool stuff or cut your hand off.  Of course, a loan can't really cut off a person's hand, but when used inappropriately, they can really make life a struggle.  And, if a person gets themself into a loan or several loans that they can't pay back, well that will hurt their credit score.  Credit scores are important for a variety of reasons, but that's for another blog.

Many people advise against ever getting a loan, while others think, "If you qualify, get it!" Loans are a tool and should been understood as such.  It's never a good idea to rush into a loan or to take on a loan that leaves the budget screaming for air when it comes time to pay the monthly bills and buy necessities such as groceries and gas.  

So, when should a person get a loan?  Well, that's up to the individual or couple, but the reality is that most people need a loan if they want to purchase a house, or even a vechicle. Some will say to save up for a house and/or a car and pay cash.  That suggestion isn't necessarily bad, but the question then becomes, "Do I pay rent, pay into someone else's equity, and have nothing to show for it?  Or, do I buy a house and build my own equity?"  Or, "If I have to drive to work, how do I get there without a car?  How do I save for a car if I get to a job without one?"  

A friend of mine is currently looking to sell their house and rent a place closer to town.  They plan on relocating in a couple of years, so it makes sense, but they have discovered that their monthly rent will be over twice as much as their current monthly mortgage payment. In the city where I live, most of the rentals have a monthly payment as high or higher than a monthly mortgage payment. Sometimes, a mortgage makes more sense than renting.  

Regarding transit, it shuts down here in Rapid City, SD, at 5:00 p.m. in town and it isn't available outside the city limits.  This is true for many small cities.  Many people live in rural areas here; therefore, having a vehcile to get to work is a necessity.  My college and high school aged teens all have to answer if they have a vehicle to get to and from work when applying for jobs.  Transportation can be a real issue for those who live in rural areas of the country.  Does that mean a person has to have a brand new car?  No, but a loan might be the only way to obtain a car in order to get to and from a job. 

Before getting a loan, it's important to understand how finanical instititions qualify people for loans.  Back before the housing crisis in 2008, it was easy to get a loan regardless of credit or work history.  The ease of obtaining a loan really put people upside down financially as they were given loans that extended way beyond what they could actually afford to pay each month; otherwise known as being "house poor."  I learned that term many years ago.  It simply means that a person or couple have enough monthly income to make their monthly mortgage payment, but they cannot pay for much else each month.  This doesn't just happen with a mortgage payment, but it can also happen with a rent payment.  Landlords get desperate for tenants and lower their credit standards and tenants let their wants outweigh their needs and their budget and take on an annual lease beyond their monthly income.

Getting a loan should make financial sense and fit well within a person's budget. Keep in mind that financial institutions have increased the percentage of how much debt a person or couple can have when evaluating a potential loan.  For example, over a decade ago, a person or couple couldn't have over a 36% debt-to-income ratio to qualify for a loan.  This ratio is calculated as all monthly debt payments divided by gross monthly income.  Debt payments would include things such as credit card payments, auto loans, mortgage, and school loans. While the threshold for the debt-to-income ratio was 36% over a decade ago, many financial institutions have raised that ratio to 41% to 45% when extending credit today.  Not all, but quite a few if not most.  

This can have a devasting effect on a person or couple's budget each month.  Many get a loan thinking they will have enough left over after paying their loan payment; afterall, the financial institution wouldn't have granted the loan.  Right?  Well, wrong.  Does this make financial institutions bad?  Not at all.  The reason is that they can't predict each person or couple's spending habits (e.g. hobbies, dining, clothing, groceries, etc.).  They analyze credit risk based on debts that must be paid each month, which doesn't include things such as utiltiies bills, cell phone bills, groceries, vehicle repairs, gasoline usage, and much more.  Also, the debt-to-income ratio is calculated on the "gross" income, not the "net" income.  Deductions vary so greatly, that there is really no way for a financial institution to use the "net" income in a ratio. Therefore, it is up to each borrower to determine what they can easily manage to pay each month.  And, it's a good idea to ask about a lenders ratio thresholds when assessing credit.

When deciding whether to take on a loan, it's a good idea to create a budget and live with it for a few months.  It needs to be managable and allow for savings.  One great way to see if a loan payment will fit within a working budget is to calculate the potential loan payment and put that dollar amount into a savings account each month.  If doing this for several months is workable and that money didn't need to be used, then that loan payment may be worth considering.  If a loan payment will be replacing a rent payment, then calculate possible expenses for home repairs, taxes, insurance, etc., and put that into a savings account each month and see how the budget handles the additional outflow of money.  In the end, if it doesn't work, you won't have taken on a loan that wasn't a good fit for your budget.