Should you take out a loan?

As interest rates fall, borrowing money is becoming more affordable and attractive. Perhaps you’ve been looking to get a new skill certification, or need to tackle credit card debt from holiday spending. However, getting a loan requires some due diligence.

A report by TransUnion found that more consumers had been missing payments in Q3 2024, with serious non-mortgage delinquencies at 1.71% — the highest level observed since early 2019. Although lower interest rates may make loans easier to repay, let’s consider all the pros and cons of a loan before you sign on the dotted line.

Reasons to get a loan

You’ll also hear about good versus bad debt, which is a general way to tell if borrowing money is a good idea. Debt is considered good when the benefit you receive outweighs the cost of the debt, and bad when it’s used for something that loses value or can’t be repaid on time. 

However, there’s no specific category of debt that’s always good or always bad. Take student loans: While they’re generally considered a good debt to increase your earning power, taking a high-interest student loan for a program that’s not well recognized or has poor job prospects makes the debt less than ideal. Consider your own situation carefully when deciding if it’s a good reason to borrow money.

What are the risks of taking a loan? Questions to ask yourself

When you take a loan, the loan is reported to credit bureaus and will be recorded in your credit history. If you don’t repay the money, your credit score will be impacted. 

Before turning to a loan as a source of funds, here are some questions you should ask yourself about the risks of borrowing money. 

Do I need the money urgently?

When it comes to large purchases, it’s often best to save up over time instead of making loan payments with interest. That said, when your income is interrupted due to illness or your home gets flooded, any emergency expenses have to come out of your pocket, even if you have insurance coverage and can make a claim.

Are there alternatives I can consider?

For instance, instead of taking a payday loan to cover an emergency repair, you could try to apply for a secured loan or line of credit with lower interest rates. Another option is to pay using your credit card, then use the promotional interest rate on a balance transfer credit card to give yourself time to pay off the debt.  

Can I afford the monthly payments on the loan?

In some cases, easy access to funds may lead to over-borrowing and give you a false sense of financial security. Review your budget to ensure you can afford the monthly payments. Otherwise, you may need to cut back on spending, reduce the amount you save, or take a smaller loan.

How long will it take to repay the loan?

The loan term determines how long it takes to repay the loan. Usually, a longer loan term means you’ll pay more in interest, especially with a fixed rate loan. 

Some loans allow you to pay off the loan early so you can pay less in interest — these are known as open loans. On the other hand, loans that charge a fee if you pay off the loan early or make extra payments are known as closed loans.

What happens if the interest rate changes?

If you’re taking a variable rate loan where the interest rate changes based on the Bank of Canada’s benchmark interest rate, consider if you can afford the monthly payments if the interest rate increases.

How to reduce your borrowing risk

If you’ve decided that taking out a loan is the best course of action, it’s wise to minimize your costs and risks as much as possible. Here are some tips to help you out:

Keep your debt-to-income ratio healthy

When applying for a loan, lenders often look at your debt-to-income (DTI) ratio to make sure you’re not borrowing more than you can afford to repay. You can calculate your DTI by dividing your total monthly debt payments — including a mortgage if you have one — by your total monthly gross income, and multiplying by 100 to get a percentage figure.

While the DTI required for loan approval varies along with other factors like your income and credit score, you should aim to keep your TDI to 40% or less.

Shop around and get pre-approved 

If you know you’ll be taking a loan in the near future, don’t put off your search for favourable rates and terms. Getting pre-approved for a loan can help you see what you qualify for and plan your budget accordingly. 

Pay off your loan as quickly as possible

The faster you pay off your loan, the less you’ll have to pay in interest. If you’ve received a bonus or have some extra cash left over at the end of the month, doing an extra payment will help you get to zero sooner. 

Understand your loan terms

As with any legal agreement, it’s important to review your loan terms carefully, especially to understand repayment terms and interest rates.

The bottom line

While a loan can be a useful tool to help you get ahead in life, it’s also a decision that should be weighed carefully against your needs and financial circumstances. Borrow responsibly and always shop around for the best loan offers instead of rushing to get approved.

Also read:

• How to pay down credit card debt with a personal loan
• Secured vs. unsecured personal loans - what’s right for you?
• Car loan calculator