By Ben Luthi
There are several reasons to consider applying for a loan. Maybe you’re planning to buy a house or a car, or you need money to make some home renovations, finance a wedding or consolidate credit card debt.
Whatever your reasons for applying for a new loan, take time to think about your reasons, your financial situation and how the debt may affect you over time. Even if taking on the debt is inevitable, this process can help you make a more educated decision about your finances.
Here are six questions to ask yourself before taking on a new loan.
There are several types of loans available, and depending on the situation, you may have choices. For example, if you’re planning to consolidate credit card debt, you could use a personal loan, a home equity loan or line of credit, a cash-out refinance mortgage loan or even another credit card.
While debt isn’t inherently bad, some loans may be better than others in certain situations. For example, unsecured personal loans tend to charge higher interest rates than loans secured by your home’s equity. They also typically have shorter repayment terms, resulting in higher monthly payments.
That doesn’t mean personal loans are objectively worse than home equity loans or lines of credit though. The latter two use your home as collateral, so if you default, you could lose your house. That means it’s important to understand both the benefits and drawbacks of each loan option.
It’s also essential to know when a loan is never a good idea. For example, payday loans and auto title loans often snare borrowers in a vicious cycle of debt, requiring them to take out new loans to pay off old ones, making it difficult to get relief.
Thinking about your reasons for taking on a new loan can help you determine whether it’s a good idea. More specifically, consider the ultimate goal and whether it’s something you might regret later on if you run into financial difficulties.
If your car is breaking down, for instance, and you don’t have enough cash on hand to replace it, an auto loan can help with buying a car to get to work and other places.
But if the car you have runs just fine and you’re on a tight budget, taking out a new loan for a nicer car may not be in your best interest in the long run.
The same goes if you’re thinking about borrowing money to take a vacation or purchase a big-ticket item. If the expense fits into the “want” category rather than being a necessity, it may be better to wait until you’ve saved enough to pay without debt.
One exception to that rule is if you’re hoping to buy a house. While you need a place to live, no one necessarily needs to own a home. But buying a home can improve your quality of life and potentially even save you money over renting. Also, homes often appreciate in value, making a mortgage loan acceptable in most cases.
Lenders use your debt-to-income ratio, called DTI for short, to determine whether you can afford to take on new debt.
Your DTI is calculated by dividing your total monthly debt payments by your gross monthly income. If yours meets the lender’s requirements, you may have a good chance of getting approved. For many loan types, the maximum DTI is 50%, but it’s typically 43% for mortgage loans.
“Keeping your DTI at a low ratio will not only allow lenders to deem you as creditworthy,” says Howard Dvorkin, chairman of Debt.com, “but also set your mind at ease with handling your own finances responsibly.”
Keep in mind that lenders don’t look at your entire budget to determine whether you can truly afford to take on new debt. You may have other financial obligations, such as medical bills, utilities, groceries and other costs, that aren’t considered debt that could make it difficult to afford another monthly payment.
Even if you can afford a new loan, consider whether it would make it difficult to set money aside for the future or to pay down other debts more quickly — this is especially important if you don’t have a healthy emergency fund in place.
To determine the affordability of the new loan, take a look at your average monthly expenses compared with your monthly take-home pay. Then calculate what your monthly payment would be with the new debt and how that would fit in your budget.
If the new debt would make it difficult to get by or it would significantly impact your ability to save and pay down other debts, it may be worth holding off until you’re in a better financial position.
Even if you decide you can afford to take on a new loan, the extra debt can be more of a burden if you lose your job or experience another financial emergency or hardship.
That’s not necessarily the case, however, if you have a lot of money set aside for a rainy day. If, for example, you have three to six months’ worth of basic expenses in an emergency fund, you’ll have a decent amount of time to get back on your feet. But if you have just a few hundred dollars saved up, taking out a new loan now could potentially make things worse later.
While the general rule is to have at least three months’ worth of basic expenses in savings, there’s no one-size-fits-all amount in practice. Take some time to consider your financial situation and whether you feel comfortable with the amount of savings relative to your debt.
The more loans you take on, the harder it can be to stay on top of your payments. In fact, a recent study found that consumers with existing installment loans who take on a credit builder loan (like one at Self) may struggle more to keep up with their monthly payments.
Not only does having more loans increase how much you owe, but it can also make managing your finances more complicated. Unless you have everything set on autopay, it’s possible to forget to make a payment.
Even if you have automatic payments set up, you’ll need to make sure you always have enough money in your checking account to cover them all. And if you’re having a hard time keeping track of all your due dates, you may slip and end up with a charge for a returned payment from the lender or for insufficient funds from your bank.
Finally, taking on multiple loans in a short period can negatively impact your credit score. Virtually every time you open a new loan, the lender runs a hard inquiry, which can knock a few points off your credit score. And with each new account, it lowers your average age of accounts, which affects your length of credit history.
“It never looks good on your part to have many different loans as this will send the wrong message to potential lenders who may feel you’re financially irresponsible,” Dvorkin says.
There’s no right answer to the question of how many loans are too many. Every situation is different, so it’s important to consider your budget, organizational skills and credit score before you proceed. Be honest with yourself about how much debt is too much.
You may be able to afford the monthly payment on a new loan, but that’s not the only financial aspect to consider. It’s also important to look at the total cost of the new debt, including fees and interest charges.
These costs can vary based on the loan type, the lender, the loan terms and your creditworthiness. If, for example, your credit is considered bad or fair, you may have a hard time qualifying for a loan with favorable terms. In this case, it may be better to wait until you can improve your credit.
Even if you have great credit, some loans are inherently more expensive than others. Check not only the interest rate on a new loan option but also the fees and the total interest charges to decide whether what you’re borrowing for is worth the cost.
“It’s always best to shop around for the best rates since most financial institutions will compete for your business,” says Dvorkin. “Also, be mindful of any hidden fees when deciding on the best loan.”
If you’ve decided during this process that taking on new debt isn’t the right decision — at least not right now — there are a couple of things you can do.
The less debt you have, the easier it will be to afford new debt. What’s more, paying down debt can potentially improve your credit score and your odds of scoring good terms on a new loan. Take a look at your budget and determine how much money you can put toward your debt, and start working on paying it down.
If you have credit card debt, that’s a good place to start. Credit card debt can be expensive and racking up a high balance can wreak havoc on your credit score.
If borrowing isn’t the right decision, but you still need cash, consider looking for ways to earn extra money, such as taking on overtime hours or starting a side hustle.
Also, consider asking family or friends for help. While you may still end up with a loan, you may be able to get more favorable terms with someone close to you than from a lender.
Depending on your situation, taking on new debt may not be an issue at all, but it can also put you in a precarious financial position.
Do your due diligence to determine if borrowing more money than you already have is the right move for you. Ask yourself these questions and any other important ones that come to mind during the process to make sure you don’t put yourself in a difficult position in the future.
Ben Luthi is a personal finance writer who has written for NerdWallet, Student Loan Hero, US News and World Report, as well as other major media outlets. He holds a bachelor’s degree in finance from Brigham Young University.