In today’s world, it is easy to go to a bank and get money, however, you should understand the disadvantages of loans before overextending yourself.
Are you just starting your early adulthood and looking for your first real job and place to live on your own? Or are you middle-aged with a family looking for a forever home? It doesn’t matter what age you are or what point of life you are in, loans can be tempting.
I have a cousin who just turned 18 years old, he has a great job that he started right out of high school and he is really doing a good job of saving some money. He is finally at his first real crossroad in life. He really wants to buy a $70,000 truck because he thinks it’s cool, but he also really wants to move out from his parents.
He asked me what he should do. He shared that he had about $20,000 saved up to put towards the truck, so his payment wouldn’t be awful, but he also knows he can’t afford an apartment and the truck. I asked him if he had considered buying a house and driving the current truck he had. He looked at me like I had six heads attached to my neck.
But it’s not just young kids that don’t necessarily understand the disadvantages of loans. My uncle, who is 65 years old, has worked hard his entire life and is about to retire. He has everything he needs, but also hasn’t put away as much money as he would have liked. I saw him last week and he told me that he wants to buy an $80,000 boat so he can use it during retirement.
That was all good and well, but I asked him how much he was going to finance of that $80K. He said likely all of it because the rates were still low, and they had a good deal. Once again, I played bad cop and asked if he thought that was the right decision. He understands he doesn’t always make the best financial decisions, but I could quickly tell I had irritated him by disagreeing with his plan.
So, two different stories of two people at completely different stages of their lives. Would either of them be wrong for doing what they wanted and buying the truck and boat? Absolutely not. However, there are disadvantageous of loans, so we must be careful to not overextend ourselves.
Please don’t read this as me saying taking out a loan is bad; I’m saying you need to calculate if every loan you take out is necessary. It is far too easy to go to the bank and ask for a line of credit and make payments in my opinion. There are several disadvantageous to loans we must all be cognizant of.
Keep reading to better understand the disadvantages of loans and the problems they can bring if you aren’t careful.
Disadvantageous of Loans:
When it comes to the disadvantages of loans, one of the biggest issues is the lack of flexibility. The biggest issue of not having flexibility is not getting out of it if you realize you made a mistake.
If you buy a brand new car and realize two months down the road that you can’t afford it, it’s likely too late. Not only do you lose 20 percent as soon as you drive off the lot, but the used market for vehicles is also often not strong.
Now, that has not been accurate for the last six months, but that is about the only time in history I remember people actually making money on loans.
So, if you get into a loan you find out you don’t like, not only are you stuck with the principal balance of the loan, but you are also stuck with the interest. Keep in mind that where they can really get you is an early payoff.
That’s right, even if you realize you are on a bad loan and need to get out of it, you can be penalized for paying off a loan early. I previously had an auto loan that I wanted to pay off because of a bonus I received at work. I was going to pay it off about 18 months early and was expecting to save around $600 in interest.
When I got to the bank with the check, they told me that there was a $350 fee for paying it off early. Now, I chose to still pay it off because I had the money and the short-term goal to pay it off. But truthfully, I should have carried the loan out because it would have made the bank less money.
My example is a very small dollar amount, but the early payoff is typically based on the percentage you owe. Keep that in mind if you have a big balance on a vehicle or even a house. I have moved five times in the last 10 years and I always make sure to use a bank without an early payoff penalty on my mortgage because I know my job can often move me.
Loans aren’t a bad thing and are one of those necessary evils (as my grandmother would say), but there are disadvantages you must think about. Just remember before you sign on the dotted line – once in a loan, there is very little flexibility to get out of it.
Perhaps the most burdensome disadvantage of a loan is a high-interest rate. Now, some loans like a mortgage or even a car loan can be at a realistic rate, but when you start talking about unsecured loans, the interest rates can be insane and the payments outrageous!
An unsecured loan is when you don’t have any collateral. So, in the case of an auto loan or a mortgage, you have the car or house to pay the bank back if you default. An unsecured loan could be to start a business, pay off other debt, or make other purchases that don’t hold value. At times you could be locked in north of 20 percent for a rate.
But now, even auto loans and mortgages are seeing extremely high interest rates. And remember as I mentioned above, once you get into a loan, there is very little flexibility to get out.
I hate that I have so many personal examples, but I fit this one perfectly. About seven months ago, I signed a contract to have a home built. They started the process in January when interest rates were still below three percent.
Now we have all but entered a recession and interest rates have climbed over six percent for a 30-year loan. That means when I was doing my due diligence on whether I can afford this house, I underestimated my payment by more than $300 a month because of the interest increase.
That may not sound like a ton, and I knew that was one of the risks of building a house with such a long timeline before closing, but that is truly a big number. Think about it – a lot of people have a car payment of $300-400 a month. Can most people afford another car? I’ll make it work, but trust me, this has caused a decent amount of stress in my household the last few weeks.
If you need a loan and it’s a well thought-out process, please do it. But understand that one of the disadvantages of a loan can be the high interest rates. And please do yourself a huge favor and avoid a rolling credit tab where interest rates can be as high as 25 percent for balances each month.
This one sounds silly to say out loud, but you do have to think about it when it comes to the disadvantages of loans. That item is a cash flow concern. I often tell my wife it doesn’t matter if you make a million dollars a year, if you spend more than that, you still have financial struggles. At the same time, if you make $75,000 a year and only spend $50,000, you’ll be doing just fine.
When it comes to taking a loan, it doesn’t matter if a bank says you are qualified for the loan; there is far more to the equation than that. Most times a bank will red flag you based on your debt to income ratio, but some of these lenders can get super aggressive and set you up for instant failure.
My recommendation? An old-fashioned budget (I know you’re all sick of hearing about this from me). There is no better way to track money coming in and money going out other than a budget. At the end of the month, if you only have $100 going to savings or you’re negative, then you really should evaluate the loan.
You may easily qualify, but if you are taking on a loan and creating a negative cash flow each month (meaning you spend more than you make), you are putting yourself in a tough situation that is hard to overcome.
Unavoidable, big expenses could be catastrophic in this scenario even if you have a big savings account and are slowly bleeding it with excess spending. What do you do the first time one of your kids breaks their arm? The transmission in your car goes out? Or does your furnace shut down in the middle of winter? I have been fortunate enough to avoid these major expenses but have heard horror stories of people not so lucky.
Personal Assets at Risk:
When it comes to the disadvantages of loans, one of the easiest things to forget about is the risk of your own personal assets. Basically, if you don’t pay your bills, collectors will come after you.
With unsecured debt, you could put things like your house or car at risk as collateral, and with any secured debt, the item you have the loan on can be put at risk. The bottom line is if you don’t pay your bills, you’ll get sent to a debt collector. It depends on how much you owe, but a debt collector could be willing to spend some money to attain assets to get your debt paid off.
Another item to watch for that can happen if you don’t pay your loans is wage garnishment. If you have unpaid loans or debts, debt collectors can go directly to where you work and hold up to 20 percent (different in each state) of your wages. They can also notify the federal and state government which would mean you would lose your tax return until the debt is paid off as well.
Trust me, this is an extreme scenario to the disadvantage of loans, but it is something that must be considered. One thing I would highly recommend is when you go to a bank to review details on a possible loan, make sure that you read all the fine print and know exactly what you are signing up for.
I read in the paper about 12 months ago, a guy from my hometown got his truck repossessed for not making the payments. When the bank went to collect the truck, it had been beaten up severely and wasn’t worth enough to cover the loan. That man had another car in his name that was paid off and through the fine print, the bank was able to collect that as well as collateral to pay off the loan.
I must stress this one more time for readers: loans are not a bad thing. I have a mortgage myself that is 30 years in length, and I understand that there are very few people in this world that can just pay cash for everything. However, there are disadvantageous of loans, so I challenge you to constantly evaluate if the loan is a want or necessity.
Five years ago, I would have taken on a car loan any day of the week because it was important. Now I’m at a point in life where my goal is to only have a mortgage payment. Any vehicle or other large purchase I make will be with cash, and if I don’t have the cash available, I must not need it that badly.
We are all built differently and all have different financial comfort levels; at the end of the day do what is best for you!