Things to Check Before Taking Any Loan

A loan can help to solve a problem now and exacerbate it the next day. 

I have seen people compare lenders and spend weeks. But only a few minutes educating themselves on the loan itself. Surprises in costs, stress in repayments or longer than anticipated repayments. 

Previously, I wrote my article, Is Taking a Loan Always Bad? When asked about loans, I explained that loan is not necessarily bad or good. The key is to know what you're taking your chances on before taking out the loan. 

Before you sign on to any type of loan, whether it is a personal loan, auto loan, student loan, or mortgage, there are some questions that you should ask yourself. A loan agreement isn't simply regarding getting money. It's about repayments, expenses, commitments and long-term effects. 

There are a number of points that should be carefully considered before applying.

Table of Contents

• Why Checking Before Borrowing Matters
• Understand Exactly Why You Need the Loan
• Check Whether the Monthly Payment Fits Your Budget
• Understand the Interest Rate Completely
• Review All Fees and Charges
• Check Your Credit Profile Before Applying
• Understand the Loan Term
• Calculate the Total Repayment Amount
• Consider Existing Debt Obligations
• Know the Consequences of Missed Payments
• Read the Loan Agreement Carefully
• Consider an Emergency Scenario
• Final Thoughts

Why Checking Before Borrowing Matters

Loan Approval is the most common mistake in the minds of many people, and they forget about loan suitability. 

Approval does not necessarily indicate that a loan is appropriate for your financial needs. Evaluating risk is a lender's job and evaluating affordability is a borrower's job. 

A loan should provide financial assistance to achieve a financial objective, not become a burden. It's important to consider all important aspects so as to avoid nasty shocks later on.

Understand Exactly Why You Need the Loan

The first question I always ask is "what is this loan used for?

“Necessary” expenses are different from “discretionary” expenses. The amount of debt that's comfortable, and why the debt is being taken on, depends on the purpose. 

I pointed out in my previous article, Difference Between Wants and Needs in Money Management, that sometimes it helps to distinguish between the needs and wants and make better financial decisions. 

Having an objective gives you a better base for all additional loans.

Check Whether the Monthly Payment Fits Your Budget

It is easy to think that a loan is afford-able if you consider only the principle amount borrowed. 

The important factor is if the monthly payment will be easily accommodated within current financial responsibilities. A payment that you can manage this week and month could be a problem if your income or expenses shift. 

That's why it's important to have a budget before getting into debt. How Budgeting Works: 50/30/20 Rule Explained mentioned that understanding monthly cash flow can aid in determining what financial obligations can be sustainably met. 

A loan payment should not be so hard to pay that it puts constant pressure into a budget.

Understand the Interest Rate Completely

Be fully informed about the interest rate. 

Many lenders think about just getting the amount they are entitled to and forget to consider how much it will cost them to borrow the amount. 

The total amount repaid over time is directly impacted by interest rates. Minor variations on the interest rate can make a big impact on the loan total price. 

I examined this topic in How Bank Interest Rates Work, which discusses how lenders determine the interest charged on loans and the impact that interest rates have on borrowers. 

If you know the interest rate, you will understand the true cost of the loan.

Review All Fees and Charges

Interest is not necessarily the only expense. 

There may be a processing fee, origination fee, late fee, prepayment penalties or administrative fees on many loans. The extra costs can raise the total cost of a loan. 

In my article Bank Fees and Charges Explained, I talked about how seemingly small fees can add up over time. It's easy to overlook the fee part of a loan agreement, and that's one of the hardest parts to read carefully.

Check Your Credit Profile Before Applying

The loan application does not start with the lender. It starts with your financial profile. 

Approval and interest rate may be affected by credit scores, repayment history, current debt, and debt utilization. 

I touched on this in How to Improve Your Credit Score Safely, where I gave a summary of how lenders interpret credit information as it relates to assessing risk. 

It's worth checking your report for any potential problems before applying for a loan.

Understand the Loan Term

The length of the loan will affect the duration of the repayments. 

A shorter time period can lead to higher monthly installments and lower overall interest expenses. A longer term could lower your monthly payments and result in paying more total. 

No one is right or wrong. It's all about knowing how the repayment plan impacts affordability and the overall cost. 

One of the most critical tradeoffs that borrowers need to take into account prior to entering into a loan contract is this one.

Calculate the Total Repayment Amount

People just look at the loan amount. 

The key number is typically the amount of repayment. This is the initial loan amount, any applicable interest and charges applied to the loan over its term. 

For instance, if you borrow $20,000, it doesn't automatically mean that you will pay back $20,000. The repayment amount may be significantly more due to interest and term. 

This number will give you an idea of the amount of commitment being made.

Consider Existing Debt Obligations

You should never consider a loan by itself. 

All debt, including credit cards, personal loans, mortgages, and auto loans, impact the ability to pay back. 

Having too many debt repayments at once can put strain on finances and decrease flexibility if there are any unexpected costs. 

That is one of the many reasons I wrote about debt management in depth in Debt Trap Explained and How to Avoid It. An issue tends to occur when fresh debt is incurred without taking into account the existing debts.

Know the Consequences of Missed Payments

When people look into getting a loan, they consider approval but not the consequences in case of non-payment. 

Late payments can lead to penalties, further interest charges, collection efforts, and impact to credit score. 

I delved deeper into this in What Happens If You Miss a Loan EMI, where I discussed the financial implications as well as future loan eligibility if you miss an EMI. 

People may have more realistic expectations if they understand the consequences before getting into a loan.

Read the Loan Agreement Carefully

When borrowers start having an issue, when they find the terms of their loan agreements. 

The terms of repayment, penalty clauses, rights of the lender, repayment schedules and other relevant clauses are typically covered in the contract. 

All of this information is worth reading up on ahead of time so as to avoid any miscommunication later.

Just a little more time to peruse the contract can save several months of aggravation.

Consider an Emergency Scenario

I often ask myself the following question: What if earnings fall off unexpectedly? 

Repayment ability may be impacted by unexpected issues such as job loss, medical costs or economic fluctuations. Taking these factors into account when you're deciding to take out a loan can help you determine if it's a manageable loan during tougher times. 

Financial plans are seldom realized as planned. It's often a good idea to leave some space for uncertainty.

Final Thoughts

The lender's approval process must not be the first step in a loan application. 

It should start with knowing the affordability, repayment commitments, loan rates and the financial ramifications of the loans. 

The objective isn't just to be eligible for a loan. The aim is to help you determine if the loan is suitable for your budget and financial objectives. 

These factors can be considered before taking out a loan to help individuals make informed decisions and avoid unexpected expenses once they sign.

Frequently Asked Questions (FAQ)

1. What should I consider before getting a loan?

Before taking a loan, review the interest rate, repayment term, monthly payment, fees, and your overall financial situation. Understanding the total borrowing cost can help avoid repayment difficulties later.

2. What should I check before taking a loan?

Check your credit score, loan eligibility, total repayment amount, lender fees, and whether the monthly payment fits comfortably within your budget. Reading the loan agreement carefully is also important.

3. What are red flags in a loan offer?

Warning signs include unclear fees, unusually high interest rates, pressure to sign quickly, hidden charges, and loan terms that are difficult to understand. Transparency is an important part of responsible lending.

4. What do lenders look for when applying for a loan?

Lenders typically review your credit history, income, debt levels, employment stability, and ability to repay. These factors help them assess the level of lending risk.

5. What are the 5 C's of borrowing?

The 5 C's are Character, Capacity, Capital, Collateral, and Conditions. Lenders use these factors to evaluate a borrower's financial reliability and repayment ability.

6. How much will a $10,000 loan cost per month?

The monthly payment depends on the interest rate and loan term. A $10,000 loan repaid over three years will usually have a higher monthly payment than the same loan spread over five years.