Cash and Debt ManagementBorrowing MoneyOverview Of Financing
Borrowing money can be a useful way for you to achieve specific goals. What are the questions that come to mind when you are faced with borrowing money? Do these sound familiar:
Should I borrow money?
Where should I borrow from? Should I Borrow Money?
There may be alternatives to borrowing that give you better results. Here are some other sources of cash that you may have overlooked:
- Savings. Look here first. In most cases, the money you have in the bank is collecting far less interest than the interest you’d pay to borrow the money elsewhere. Of course, it’s not wise to tap into your emergency fund, but if there is extra cash, you will want to look at this option before borrowing.
- Selling assets. Selling some shares of stock or, for example, property in Florida that you inherited, could be more beneficial than borrowing. Don’t misunderstand -- we are not advocating that you hock your valued possessions. But if there is an investment that should be sold, i.e., converted to cash, then you may want to consider selling an asset before borrowing money.
Total Cost of Borrowing
This chart shows the total cost of borrowing $20,000 at various interest rates and repayment periods.
| Interest Rate |
5-Year Loan |
10-Year Loan |
15-Year Loan |
30-Year Loan |
| 8% |
$24,300 |
$29,100 |
$34,400 |
$52,800 |
| 9% |
$24,900 |
$30,400 |
$36,500 |
$58,000 |
| 10% |
$25,500 |
$31,700 |
$38,700 |
$63,200 |
| 11% |
$26,100 |
$33,100 |
$40,900 |
$68,600 |
| 12% |
$26,700 |
$34,400 |
$43,200 |
$74,100 | As you can see, borrowing can be costly, especially if you take out a long-term loan. It’s important to look at other alternatives to borrowing before making a final decision.
Before you borrow, you should compare the after-tax interest rate you are earning on your assets to the after-tax interest rate you will have to pay to borrow money. For example, suppose you have the $20,000 you need in a savings account earning 5% interest. After paying taxes on your interest (e.g., at a rate of 25%), you are really earning an after-tax rate of 3.75%. Unless you can borrow money at an after-tax rate below 3.75%, you’d be better off using the money in your savings account (unless it’s your emergency fund). See the following example using a 25% marginal tax rate on how this after-tax interest rate is arrived at.
| a) Current Interest Rate |
5.0% |
| b) Marginal Tax Rate |
25.0% |
| c) Multiply (a) times (b) |
1.25% |
| d) After-tax Rate of Return |
| Subtract: (a) minus (c) |
3.75% | If you have to pay a higher interest rate to borrow than what you are currently earning on your savings (after-tax), it would pay for you to use your savings rather than to borrow.
Think Before You Borrow - Key Considerations
It’s important that you go through a series of steps before deciding if you should borrow money. Here are the steps:
- Look at all the borrowing options available to you. What’s cheapest? Using money in a bank account? Selling a stock or a mutual fund? Or borrowing the money?
- Can you afford it? What does your current loan situation (including credit cards) look like? If you are already heavily in debt, you may want to reconsider borrowing and wait until you are in better financial shape.
- Consider potential tax benefits. If the interest you pay is tax deductible, it reduces the net cost of borrowing. The IRS disallows almost every type of interest expense deduction, except for some interest on home loans, investment interest expense and possibly some interest on student loans. So, if you are a homeowner with equity in your home, there may be a tax benefit associated with mortgages and home-equity loans.
- Evaluate your attitude towards borrowing. Learn to use debt wisely. You shouldn’t go into debt to live for today and pay tomorrow. You’ll need to adjust your attitude towards debt. Nor should debt be avoided at all costs. If your mortgage rate is 7% and you can earn 9% on your investments, it’s better to be in debt and earn more on your investments. When used wisely, borrowing can be a useful tool to reach your financial goals.
Where Should I Borrow From?
Once you decide that you have no alternative to borrowing, you’ll see that there are a variety of ways to accomplish your borrowing objectives. So, before you go any further, look at the different sources of cash that are available to you.
- You are a homeowner with equity. There are some attractive ways to use the equity in your home as a means of getting cash.
- You are not a homeowner or have no equity in your home. You still have several different options to consider for borrowing money.
- You can easily borrow from family members.
When You’re Done Working With This Section You Will:
- Have a clear understanding of your financial situation.
- Have a good grasp of your spending patterns.
- Be able to identify your strengths and weaknesses in dealing with money.
- Learn some helpful hints about saving money.
- Know what your goals are.
- Learn how to reach those goals by making some simple changes.
- Know the legal alternatives available to you.
- Learn about the different ways you can borrow money to pay off your debt.
- Know when you should - and when you should not - refinance your mortgage.
- Be able to make informed decisions about getting a home-equity loan.
- Know what your options are when you need a loan to buy a car.
- Understand why, in most cases, loans from qualified retirement plans are not recommended and,
- Have a strategy in place for borrowing money, for whatever reason, that makes sense for you.
Article Content by Truebridge, Inc. All rights reserved. Copyright 2001-2010 |
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