Borrowing can be a good financial strategy if it helps you acquire something large — like a house or an education — that could add to your net worth. It can also help you get things that you can’t easily save up for quickly, such as a car. As with any debt, consider the interest costs and only borrow what you can afford to pay back. Before you borrow, ask a few key questions to determine if taking on debt will be manageable for you.
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When does it make sense to borrow money?
You may hear people talk about ‘good debt’ and ‘bad debt’. But there’s not always a hard and fast rule about whether a type of debt is good or bad. It is more a matter of how expensive the debt will be, and whether you will be able to pay it off in a timely manner.
Some types of debt can help you gain an asset that will be valuable for your day-to-day life. Examples of these include:
- Paying for education – Post-secondary education can be expensive, and difficult to pay for from your own savings. Taking on a student loan can be a good investment in the long term, since getting a degree might mean you’ll make more money when you enter the workforce.
- Buying a car – If you need to buy a car, you might have to take out a loan or lease to pay for it. Always weigh the cost of borrowing against using your own savings. And if you live in a city with accessible public transit, consider the costs of driving compared to using transit.
- Buying a home – If you choose to buy a home, you’ll likely need to get a mortgage. Although buying a home isn’t for everyone, it can be a good investment if the value of your home increases over time and you’re able to manage the payments.
- Starting a business – The type of loan you need depends on how much you want to borrow, how you plan to use the money, how long you’ll need it, and how you’ll pay it back. Your borrowing options may include banks, trust companies, credit unions, government agencies, or family and friends. Make sure you have a solid business plan and a strategy for paying back your business loans.
- Paying off debt at a lower interest rate – If you have a lot of high-interest debt, consider paying it off with a lower-interest rate consolidation loan. Two common options are a home equity loan or line of credit. The interest rate may be low, but keep in mind that you could lose your house if you don’t make the payments.
Borrowing to contribute to your RRSP
If you contribute to a Registered Retirement Savings Plan (RRSP), you could get an RRSP loan as a way to contribute. Using an RRSP loan can ensure you contribute to your RRSP before the annual contribution deadline on March 1. RRSP contributions are tax deductible, which means you could lower your taxes by contributing, and you’ll be saving for your future. However, you’ll need to repay the loan within a year to reduce the amount of interest you’ll owe on the loan. If you’re not confident you can repay your RRSP loan in a timely manner, then the benefit of the loan may be outweighed by the costs of repaying it.
What questions should you ask before borrowing money?
When you take on a loan, you agree to repay the money under specific terms. The loan will become part of your credit history. Your record of repaying debt will stay with you. It’s important to make sure the loan is right for you and that you understand all of the conditions you’re agreeing to.
Before borrowing money, ask yourself these six questions:
1. What is the total amount you’ll repay?
Find out how much the loan will cost when you add up all the interest you will pay, as well as all of the money you borrowed. The interest rate will depend on the type of loan. Some interest rates are fixed for the whole term of the loan. Others may go up and down as the Bank of Canada rate changes.
For example, let’s say you borrow $10,000 from your personal line of credit, and repay $500 a month at 7% interest. It would take you almost two years to repay and you would end up paying almost $664.41 in interest.
2. How much will you need to pay each month?
Review your budget to make sure you can afford monthly loan repayments. If it feels tight, you will need to consider what expenses can be reduced to accommodate paying back the loan or reconsider getting it.
3. How long will it take to repay the loan?
The length of time it takes to repay a loan is called the loan term. The longer the term of your loan, the more interest you will pay (if the interest rate stays the same). Find out if there is a penalty for paying the loan off early. Some lenders charge a fee if you make extra payments or repay the whole loan early. Others offer more flexible options.
Our Mortgage Payment Calculator can help you calculate your monthly mortgage payment, including interest.
4. Could the interest rate change?
The interest rates on loans, such as variable rate mortgages and a line of credit, can change if the overnight lending rate changes. Also, if you have a fixed rate mortgage, it’s likely the interest rate will be different when you need to renew it after the first five years of the term.
Additionally, with some loans, the interest rate might increase if you don’t make a payment by the due date.
5. Is the loan secured?
The interest rate on a secured loan will often be lower than an unsecured loan. But if you don’t pay back the loan, the lender has a legal claim to whatever you use to secure the loan. That might be your home, your car or other property.
6. Do you have to pay for any insurance?
Your lender might require you to insure your loan. This means the lender will make your monthly payments if you can’t for specific reasons, such as getting sick and being unable to work. If loan insurance is optional, find out how much extra it will cost and what it will cover. You may decide you don’t need the insurance.
If you’re uncertain about the answers to any of these questions, it’s a good idea to take time to review the loan conditions carefully before committing.
If you haven’t made a monthly budget before, it’s a good idea to get into the habit before taking on a large loan. Try our five steps to creating a budget. If you’re not sure where to cut back on spending to free up room, tracking your expenses for a couple of months can give you a lot of useful insights.
How can you reduce your borrowing costs?
Repaying a loan can get expensive the longer you take to pay it off, and if your interest rate increases. A little bit of planning ahead can reduce your costs, but there are often some steps you can take to repay your loan faster.
Consider these four tips for reducing your borrowing costs:
1. Borrow only when you need to
Borrowing can make sense. But there’s always a cost: the interest you pay. In general, borrow only when you need to — and to pay for things that have lasting value or the potential to go up in value. This means avoiding taking on debt to cover everyday expenses or splurges.
2. Borrow only as much as you need to
Be mindful of how much debt you are taking on — not only mortgage payments or student loan repayments but other debts such as credit cards or line of credit. The more you need to repay each month, the less you’re able to put towards savings, investments, or day-to-day expenses.
Once you establish a debt repayment history, you may start to receive more offers from your financial institutions, for example pre-approval for credit cards or a higher line of credit. These can be tempting, but also risky if you end up taking on more debt than you can afford. If a new credit card would meet your needs — for example with a better interest rate or better rewards — then consider closing your old credit card at the same time.
3. Shop around and plan ahead
If you’re making a major purchase, like a house, a fraction of a per cent can save you thousands of dollars. Make sure you know the right questions to ask before you borrow.
It’s often easier to negotiate a lower interest rate when you have time on your side. It may also be easier to get approved for certain types of loans, like lines of credit, before you may need them. Another idea is to get a pre-approved mortgage if you know you’re going to buy a house.
4. Look for ways to pay down your debt quickly
The faster you pay off the principal, the less interest you’ll pay in the long run. Look for ways to repay more than the monthly minimum. If you’re repaying a credit card debt, even paying $20 more per month could make a big difference. Use this calculator to figure out how long it will take to pay off credit cards and other debt.
If you’re paying down a mortgage, there are several ways you could pay it down faster. For example, making payments biweekly rather than monthly can save you a lot of interest. Also, many lenders will let you make an annual lump-sum payment in addition to your regular payments. This will reduce how much you owe and help you reach the end of the mortgage sooner.
One of the best ways to avoid taking on unnecessary debt is to keep an emergency fund. When you’re caught by surprise with an unexpected expense, you’ll have a financial cushion to cover it or to see you through a couple of tight months if necessary.
Summary
There isn’t always a hard and fast rule about whether a type of debt is ‘good’ or ‘bad.’ This will depend on whether the debt will help you meet your goals, and whether you’re able to repay it. Remember:
- Before you take on a new loan, ask key questions such as: What is the interest rate, how much will you need to repay each month, and how long will it take to repay the entire debt plus interest?
- If you haven’t made a monthly budget, it’s a good idea to make one now so you’ll know how much you debt you can afford to repay each month.
- The best way to reduce your borrowing costs is to not take on any debt you don’t need.
- Shop around for the best lending rates if you can and look for ways to repay the amount more quickly.
- The best way to avoid taking on unnecessary debt is to keep an emergency fund. You’ll be covered for a surprise expense and won’t need to repay interest.
