Though living a debt-free lifestyle is a good life goal, it’s also important to educate yourself about borrowing money wisely and responsibly. For example, taking out a loan to buy a house or a car. We asked 11 Canadian financial experts one question. Heed their advice and gain the knowledge you need to borrow safely.
How can Canadians take steps to borrow money wisely?
Here are three general rules that will help to ensure that when you borrow money, you are doing it wisely.
First, never carry a credit card balance. If you can’t afford to pay for an item in full at the time you purchase it, you probably shouldn’t buy it.
Number two, never finance a vehicle longer than five years. Car companies are selling people cars they truly cannot afford, by stretching car loan payments over six or seven years. It’s a bad idea.
Last, but not least, always buy less house than you can afford. When you are prequalified for a mortgage, your bank gives you a maximum approval amount. The problem is, buying a house at the upper reaches of what you can afford only leads to financial stress. Especially when you factor in all the other costs that come with owning a home.
If Canadians want to borrow money wisely, I’d advise to first look at their credit report. Look for any inconsistencies. Borrowing money is not something to take lightly, so calculating your debt-to-income ratio is also critical, so you know how much money you net and owe.
Adding more debt to what you already owe may not be the best idea. Especially if you are already sailing with a tight budget. Determine how fast you want to pay back the loan, and whether your budget can accommodate it. Don’t bank on overtime wages or earning extra money to fund your borrowing, either.
Shopping around for the best loan is also important, because different lenders will offer you different rates. Even the smallest percentage difference can cost you hundreds or thousands of dollars.
Finally, use the money wisely.
Canadians are facing record levels of debt, and that debt has created a great deal of stress, and even sleepless nights for many consumers. When you borrow wisely, however, you can achieve some goals sooner. For example, you could renovate your house instead of moving, or fund your dream of going back to school. A professional like a Certified Financial Planner can guide you by looking at your overall budget today, projecting your financial situation and cashflow in the future, and helping to figure out how much you can afford to borrow, while achieving your other financial goals.
Before borrowing any money, ask yourself why you’re borrowing the money. Is it for an appreciating asset or something that can help grow your net worth, such as real estate or student debt? Then it may be a good idea. If it’s for something that depreciates in value like a boat, it’s better to think twice about it.
One way to borrow money wisely is to figure out how much of a loan you need and shop around for it. It is a good idea to check with many different lenders. Compare interest rates and review your payment plan before making a decision. Another important thing to do is to read the terms and conditions to understand important factors like fees and penalties and what would happen if your situation changes and you would like to move to another lender.
Research interest rates of different lending institutions. Ask questions and understand how flexible the repayment terms are going to be.
Debt servicing costs continue to eat into the disposable incomes of Canadians. While the best-case scenario and my advice for most people would be to avoid personal loans of any kind, the reality is that not everyone can afford to not take on credit at some point in their lives.
If you must borrow money, follow these smart tips:
- Keep your borrowing to a minimum. This is another way of saying you should only borrow the money you can afford to pay back quickly and easily.
If your need is for $10,000, don’t be tempted to increase your loan to $15,000 simply because the lender approves you for a higher loan amount.
Avoid taking out a loan for non-essential things (for example, a vacation). If it’s something that can wait, consider putting together a plan to save up for it.
- Understand the terms and read the fine print. How much is this loan going to cost you? Over the term of your loan, how much are you going to be paying in interest payments?
If your $10,000 loan is going to cost you an additional $8,000 in interest over say a 5-year term, consider whether or not it is worth taking on.
Find out if there are other associated fees: loan origination fees, late payment fees and prepayment penalties.
Ensure you understand how the lender calculates their APR.
- Keep an eye on your credit score. Lenders use your credit score to assess your creditworthiness. A very good to excellent credit score means you can qualify for loans at competitive rates.
Check your credit score for free online to see where you stand and what rates to expect.
Transunion and Equifax provide Canadians with one free credit report per year, upon request.
Note that when your credit file is pulled multiple times by lenders within a short period of time, it impacts your credit score negatively, making it more difficult to qualify for a loan.
Checking your own score does not affect it.
- Shop around for the best rates. A lower interest rate can help you save hundreds to thousands of dollars in interest payments.
Compare rates and terms across lenders to ensure you are getting the best rate possible.
Check with your bank, credit union, digital bank and others. Read reviews, check with the applicable regulator, the Better Business Bureau, and other sources to confirm whether a lender is reputable and also to avoid loan scams.
- Make payments on time. Don’t default on your scheduled repayments and plan to pay off your debt as soon as possible. The longer your loan term, the more you pay in interest fees. Note that if you are looking to save on interest costs, making just the minimum payments won’t cut it.
When you have more than one debt, direct your extra funds towards paying off the one with the highest interest rate first.
If you do not have an emergency fund, now is the time to start saving up for one. An emergency fund can remove the need for a loan when unexpected expenses arise.
- Shop around: The interest rate you end up paying and the amount (if any) you can borrow will depend on several factors. Your credit score is an important one. A poor credit means higher risk and therefore higher interest rates are needed to compensate lenders for that higher risk. However, not all lenders charge the same rate even when risk is considered. You can often get a wide range of rates and borrowing amounts if you shop around.
- Use a broker to help you shop: The problem with shopping around is that people often do not have the time or the skills to do so effectively. Hiring a broker such as a mortgage broker can be a great way to bridge the knowledge and time gaps. They would also generally only pull your credit report once. Shopping around alone and having your credit report pulled many times in a short period can have a negative impact on your credit score and hence your interest rate.
- Build good credit: If you have bad credit, shopping around whether alone or with the help of a broker may still not yield good results. Bad credit will limit your options no matter what – which is not to say there are no options. Usually people with bad credit do have lending options, just not very good ones. However, you may need to accept them anyway as a means of building your credit back up to a decent level. Receiving a loan and making timely payments every week/month is a great way to build good credit over time.
- Learn the difference between “good debt” and “bad debt”: These are subjective terms and there is plenty of room for disagreement on what exactly qualifies as good versus bad debt. However, it is generally accepted that a mortgage on a home you can afford is an example of good debt and spending borrowed money on non-essential consumer items is generally viewed as bad debt, especially if a credit card with a >20% interest rate is used to fund the purchases and a balance is carried.
- Don’t get overextended / live within your means: Nothing helps without this last one. If you are going to borrow as much as you can, including within the “bad debt” category above, then really nothing will help. You should never borrow more than you can repay. One trap to avoid with couples is borrowing an amount based on both incomes – if one person loses their job or gets sick, the other cannot continue payments. If you do borrow based on both incomes, make sure disability and life insurance are both adequate and you have enough emergency funds to weather a storm. Considering what happens in the event of a separation and whether you would still be able to pay is another important consideration in determining how much to borrow in the first place.
- Stay on top of repayments. The importance of on-time payments cannot be overstated. Remember that a loan is a great credit-building opportunity. But if you miss a payment, it will negatively impact your credit score. Do not miss a single payment due date. Automate payments if necessary.
- Avoid the temptation to extend your loan term. If you get a personal loan, you do not need 72 to 84-month terms. If you do need a term this long, you are living beyond your means.
- Know who to trust. Online lenders are emerging as a legitimate competitor to traditional bank loans. But you should learn the telltale signs of an untrustworthy lender. Companies that offer unsecured personal loans with no credit check and/or guaranteed approval are suspect. If they do not have a physical address or contact information either, they are not to be trusted.
- Borrow as part of your debt reduction strategy. It might sound counterintuitive, but a personal loan or balance transfer card is a good idea. Use it for consolidation purposes or paying off higher-interest debt.
- DO NOT GET A PAYDAY LOAN. Payday lenders are accessible to even the most credit-challenged customers. But the short repayment cycles and sky-high interest rates make them predatory by nature and EXTREMELY HIGH RISK. Avoid them at all costs.
- Keep your credit card balances low. You might not even notice the interest you pay on credit card debt, but it adds up. Think of the opportunity cost; you could be using that money to pay off other debts. Also, low credit card balances mean low utilization, and that’s great for your credit score. Avoid falling into the bad habit of carrying a balance from month to month and only making the minimum payment.
- Use credit cards responsibly. Credit cards can be used to spend the cash you have and earn points. Not to splurge and live beyond your means. Don’t sacrifice tomorrow for today.
- Only apply for the credit you need. New applications for credit mean more inquiries on your credit report, and too many inquiries over a short space of time can damage your credit score.
- Don’t close your credit card accounts. If you have too many credit cards, it doesn’t always make sense to close the accounts. Instead, pay them off and don’t use them. Closing credit card accounts can reduce the average length of your credit history, and that’s not good for your credit score.
Shop Around, But Not Too Much: Attempting to secure the best rate and conditions for a loan – just like looking for the best price on your new TV – is a good idea. Shopping around too much, though, may result in unfavourable side effects. Hard inquiries negatively affect your credit score, especially if numerous inquiries are made in a short period of time. Although inquiries on certain types of loans (mortgages, car loans) are not as stringent, shopping around for loans can negatively impact your credit score. You’re better off independently collecting information from a financial institution’s website and narrowing down your options first to minimize your recorded search.
Timing Is Everything: Issuing loans is risky business for lenders. Depending on where your business is in its life cycle, though, that risk can vary wildly. When a business is in its startup phase, doesn’t have an established market presence, or lacks historical financial information, the bank incurs a higher risk, and the business should expect higher interest rates, more restrictions, and lower approved credit lines. It will also be more difficult to receive a loan in these scenarios, so keep that in mind if you’re thinking about getting one. There’s a reason the biggest companies in the world take out debt when they’re doing well: that’s when the balance (and the cost of capital) is in their favour.
Negotiate Your Rate: It never hurts to ask for a lower rate, something like 0.5% lower than what you’re quoted. You’d be surprised how often you’ll get a lower rate just by asking for it!
The first and most simple step you as a Canadian should make before borrowing money is to know your credit score. This simple three-digit number will have a big impact on the chances of you receiving a loan, and even more importantly, the interest rate of said loan.
Luckily, you can easily receive a free copy of your credit report and credit score by mail from both of the major credit bureaus in Canada: TransUnion and Equifax. There are also a couple of services you can use to get your credit score for free online. However, keep in mind that these scores may not be as accurate as the scores provided by the official credit bureaus listed above.