Here in session number 17, we’re going to be talking about Borrowing Money. Most of us need to borrow money at some point, and this can be from family, friends, banks or sometimes from the shadier end of the lending market.

In this session we’ll talk about how to borrow money wisely and in a way which doesn’t scupper your future success.

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Introduction

I spent session 4 of this podcast talking about how to get rid of debt once and for all, so why now talk about getting into debt? I’m a realist – most of us have to borrow at some point, so we might as well do it right.

Let’s look at some stats about borrowing in the UK Source: Credit Action

• Average household debt in the UK (excluding mortgages) was £5,971 in April 2013
• Average consumer borrowing (including credit cards, motor and retail finance deals, overdrafts and unsecured loans) per UK adult was £3,204 in April 2013
• Citizens Advice Bureaux in England and Wales dealt with 8,192 new debt problems every working day during the year ending December 2012.

Seems like borrowing is a big issue, and that last statistic shows that it is a big problem for too many people. The problem is we don’t know how to borrow money wisely, and if you get it wrong, it can lead to a downward spiral of borrowing to pay off previous lenders. That way bankruptcy lies.

Important – If debt is becoming an issue for you, this is not the session for you really. Listen to Session 4 instead. There are links there to get help.

So, as ever, let’s arm ourselves with the good stuff, the information you need to KNOW and the steps you need to DO if you’re going to borrow money wisely.

Everything you need to KNOW

1 – Not all borrowing is bad

There is such a thing as bad debt and good debt. Or perhaps we should call it bad debt and not-so-bad debt! The ideal scenario is that you never have to borrow money at all.

I quote a Forbes magazine study, back in session 4. The Forbes 400 list, which are the 400 richest people in America were asked about how they had become wealthy and their best advice for others hoping to become wealthy. Three quarters of them said the best way to become and stay wealthy was to stay out of debt – I’ll take their advice.

It’s pretty clear which kinds of debt are bad:

• Payday loans – short term loans, usually repayable in 30 days or less, designed to get you to your next pay day. These are a very bad idea, and you should do everything you can to avoid ever taking one of these out. The interest rates and other charges are staggering, often with four-figure interest rates – 4000% per year anyone?
• Store Cards – Usually we get offered these with the enticement of an immediate discount on the stuff we’re buying. Don’t fall for it. These are among the highest charging cards out there, and let’s face it, do you really need another bit of plastic in your purse or wallet? All the promises made such as early access to discounts and new lines are so much fluff intended to hide the fact that you’ll be bombarded with junk mail and overcharged if you ever rollover some debt from one month to the next.
• Credit Cards – thought cheaper, usually, than store cards, Credit Cards usually still charge in the double figures percent in interest – surely there is a better way?
• Overdrafts – the bank allows you to go into the red; a negative balance on your bank account. Expensive because they’re meant to be temporary

There is a pretty fool-proof rule of thumb to determine which debt is good and which is bad – is the thing you are borrowing money to buy going to increase in value or not?

Clearly clothes bought on a store card are not going to increase in value, so that’s bad debt. Food bought with a payday loan the week before you get paid is not going to go up in value – bad debt.

Property usually goes  up in value, which is why mortgages are generally seen to be a good form of debt. As long as the repayments are affordable, then you’re good to go. Much more detail on next week’s session which will be an introduction to mortgages – thanks to Twitter user @buttaznang for the prompt on that one.

Car loans are a bad idea because cars always go down in value.

Not always clear-cut though.  I used this example in session 4 – what if you need a car to get to work and further your career, but you need to borrow to buy it? Even though the car will depreciate, go down in value, you are using it to get to your job. Is that a good debt or a bad debt?

Good question. I think if you need to borrow to buy for this reason, then that’s fine, as long as you buy the cheapest viable car you can and get the best rate you can. Don’t use it as an excuse to borrow ten grand to get a nice car. Earn the money, save some of it and try to buy your next car outright. Sound impossible? Check out video Episode 245 – How to buy a car debt free.

2 – Borrowing from friends and family is usually bad

Most of us need to borrow money at some point and an obvious source of borrowing is family and friends. I suggest that you avoid this if at all possible, though even this is preferable to a payday lender.

Why? There is nothing more likely to change the dynamic of any relationship, than to borrow money. Think about it, every time you see them you’re going to be thinking about it. A formerly jovial relationship with a mate is going to be overshadowed, because now there is something between you other than the friendship. It’s now a master-servant relationship – very different.

Or perhaps you borrow from your parents, and then you catch the disapproving looks when you mention that you went out for dinner or (worse) that you have booked a holiday. And what if you can’t pay them back, or have to miss a payment?

Money has the power to destroy relationships, even tearing close families apart. It’s just not worth it, but if you do, set up a regular direct debit to pay them back, and make sure there’s enough money in your account to pay it. Eat Baked Beans for a year if necessary, but make these payments! Nothing is worth messing up relationships for.

Note that a gift is different, if your parents want to give you some money, that’s not a debt. A gift should be freely given without strings, and should be gratefully received and enjoyed!

3 – Learn the terms

It is worth learning the terms specific to borrowing money. many a fairly straightforward, but here are just three terms, which can easily confuse first-time borrowers:

APR – Annual Percentage Rate. This is close to, but usually not exactly the rate you’ll pay because it likely includes any set-up charges, early repayment charges etc. It’s designed to help you compare loans of differing types and is like a total cost of borrowing. More important than this percentage is the pounds figure you’re going to be paying back each month – can you afford it?

Secured/Unsecured – Secured loans are where the person lending you the money takes ownership of something until you pay them back. So a mortgage is a secured loan, because the bank essentially owns the house. A car loan is the same. If you stop paying the loan back, the ‘security’ property is taken off you, or repossessed.

Credit scoring – When assessing you for a loan, a lender will often credit score you. This is a measure of your credit-worthiness; the likelihood of you being able to pay back the loan. The outcome of this score will determine the interest rate you get offered or could even mean you don’t get lent the money at all.

So we know the difference between good and bad debt, acknowledged that borrowing from friends and family is a bad thing, and learned the meaning of some confusing terms, let’s look at what you need to do if you’re considering borrowing money for something

Everything you need to DO 

1 – Do your budget sums carefully before borrowing

You need to get your spending under control before you even think about borrowing money. Can you afford the repayments? If your repayments are variable like on many mortgages, can you still afford the repayments if interest rates go up?

Doing this homework before your borrow money will also help to stop you from borrowing money on the spur of the moment, which is always a bad idea. Make sure you’ve thought things through properly before putting yourself in hock for five years on a personal loan, or for 25 years on a mortgage.

2 – If you must borrow, get the best interest rate you can

Startlingly original thinking I know! There is no doubt that the best way to buy anything is for cash. It costs you nothing, and there is no risk to you. The thing you buy will be yours and no-one can take it off you. But if you must borrow, like for a house, you should find the best interest rate you can. Notice I don’t say the lowest…

Look at charges and terms as well as the raw interest rate. Sometimes the lowest rate isn’t necessarily the best. A low rate with an upfront charge, might be worse than a higher rate with no upfront charge. That’s why the APR thing can be handy, but do your own sums. What is the total amount payable? Look at this closely.

Can you pay the loan off early? Are there any penalties for doing so? Can you overpay? The more flexible the loan the better, as long as the flexibility doesn’t come at the expense of a higher rate.

3 – Look at all possible alternatives to borrowing

It just might be possible to get what it is you’re after without borrowing. Consider some alternatives:

Delay purchase and save – We live very much in an age of instant gratification, and I’m all for that! But if the only way to get something now is to borrow, surely it’s better to wait if possible? I’m not preaching, I know what it’s like to really want something now. But its great discipline and really satisfying to buy something with cold, hard cash. Very often, you might get a discount too! Try it… Obviously, you might not be able to do this for a house!

Dip into emergency fund – Only if it’s really an emergency, like your boiler blows up or something. Of course, you have to have an emergency fund to start with! Don’t use your emergency fund for a holiday. Once your emergency fund is in place, use that money that you save each month to save for things you need or want.

4 – Be very careful if considering borrowing for investment

Borrowing for investment – called gearing – is not for the faint-hearted. It does depend what you’re borrowing to buy though. If you’re borrowing to buy a rental property, make sure you can afford the mortgage repayments even if you don’t have a tenant, or if your current tenant stops paying you. The underlying asset will probably be a good investment over the long term, but that is not guaranteed. Remember that property is illiquid – difficult to sell if you need the money quickly.

Some people have asked me for my opinion about borrowing to invest in the stock market in some way. Their logic is fairly sound – interest rates are low, and returns in the stock market can be high. So as long as you’re making more money than the interest payments, you’re in profit.

But be careful. Borrowing massively increases the risk of any investment. What if you borrow to invest, and then lose some or all of the money? Not only do you owe the money, but you don’t have the thing you bought with it any more because shares have crashed or whatever. Pretty much a worst case scenario. Only do this if you are prepared and financially able to cope with the loss of your investment and the requirement to pay the loan back.

5 – Quick tips

• If you have a credit card balance, pay 10% off it every month. This way you’ll get that balance down faster. If you just make the minimum payment, you will be paying it off forever.
• Don’t borrow from loan sharks, and I include payday lenders in that definition. Better to go just about anywhere else than this. Try the local credit union.
• Don’t ever borrow money to pay off other borrowing. This is called debt consolidation. Dave Ramsey emphasises the first three letters of this word, CONsolidation. Debt consolidation rolls all your existing debts into one bigger debt, spread over a much longer time period. This brings your monthly payments down, but doesn’t fix the root cause. Too many people who do this end up maxing out their credit cards again. Far better to get out of the debt you already have. See video episodes 238, 239 and 240
• Be careful about interest free deals. Often they’re only interest free for a certain length of time, after which the interest cranks right up.

Summary

I think that covers what you need to know and do when it comes to borrowing money. Again, the best scenario is not borrow at all, but life throws things at us that mean many of us have to at some point. Golden Rule: Always consider borrowing as a last resort.

Outro

That's it for this session of the MM podcast, I hope that was helpful.

Did I miss anything? Any questions or comments? Please leave any comments or questions below and I'll do my best to answer them

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I hope you enjoyed this session

Next time we'll be talking about mortgages, the one loan that most of us have to take out. If you have any questions about this, go to meaningfulmoney.tv/feedback and leave a voicemail

Thanks for listening – I'll talk to you next time