Whenever you think of a loan, what comes to mind?
I grew up with a bad perception about loans. I was of the opinion that taking a loan is bad and signifies poverty. If we were to do a poll, the result would change, from individual to individual.
Now, as an adult, with a background in finance, I can tell you that this is a myth. An understanding of loans needs to be communicated. Did you know that access to credit is critical for the growth of an economy? The private sector needs affordable loans to push and stir growth. But today, my focus is on individuals.
So what does taking a loan mean to you?
1. Having access to credit signifies that there’s a probability that you can repay.
2. Helps you build a credit record.
3. Portrays you as a lower risk than those who can’t access it at all.
1. Having access to credit signifies that there’s a probability that you can repay.
2. Helps you build a credit record.
3. Portrays you as a lower risk than those who can’t access it at all.
Now that we have addressed some of the perks that come from taking a loan, we need to talk about the critical elements of it. We have two categories of loan: a good loan and a bad loan.
A good loan is a loan that provides future benefits. That means you’re incurring a loan to acquire an asset. It ranges from real estate, education or healthcare. The key feature about this asset is that it provides a future benefit. So before you take that loan, ask yourself what it will be used for.
A bad loan is a loan incurred on consumption or an expense, with no future return. This could be used to purchase clothes, shoes, or a bigger rent. For this kind of purchase, if there is no future benefit and it is strictly for an immediate consumption, you should rather delay that consumption and save toward it. Save for that travel, save for that premium bag. You can avoid the cost of paying for a loan when you can instead save toward the consumption.
There is another class that is also considered as a bad loan. On the surface it might look like an asset, but because it is not a necessity, it is wasteful… if you have to fund it via a loan. For example: a second car. Realize how this isn’t a necessity.
We’ve spoken about costs a couple of times, but really, what does your loan cost? Are you aware? If you need a loan, these are the typical sources people go to: friends and family, commercial banks and micro finance banks. So your family and friends might give you a loan without terms and conditions and some might charge you. You should pay attention to the cost, if they charge.
For commercial banks, it ranges between 18% to 26% per annum, depending on your risk profile. Pay attention to it, it is important. For micro-finance banks, some charge 5%, while others could charge as high as 10% per month. You need to pro-rate it per annum, that way you know the annual cost. If it is 5% per month, that’s about 60% in a year, and if it is 10% per month, that’s 120% in a year. Considering how high this cost is, it should only be considered for a short term loan. Something you need quickly. Also, remember that your loan compounds: the longer the duration of the loan, the higher the total interest expense
For example: If you borrow ₦100,000 at 5% for 2 months. You will pay back ₦110,000 after 2 months. If you borrow ₦100,000 at 5% for 12 months. You will pay back ₦160,000 after 12 months. This is assuming that you pay back the capital and interest at once. In summary, shorter term = lower interest expense.
The last consideration is if you are taking a loan to invest. Compare the cost of the loan to the return on what you’re investing in. Some investments, such as education, are subjective. It’s imperative that while you’re computing your return on investment, you also look out for qualitative factors. For example, you take a loan at 26% per annum from the commercial bank to invest in t-bills that gives 12% per annum. You just made a poor decision.
The whole purpose of this exercise is to ensure you’re making a sound financial decision and you’re aware of the costs involved. A loan can be a sound decision, depending on how you use it.
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