I’ve recently wrote an article titled “Avoiding the slippery slope of debt” in which I wrote about how quickly small loans may amount to significant debt and mentioned ways of avoiding it. However, there are cases where we simply must finance ourselves with the bank’s money. As with anything in life the middle way is the right way.
Financing and leveraging by themselves are not bad. They are merely tools which should be put to good use.
Taking a loan or any sort of external finance is reasonable when the return is usually expected to outgrow the financing costs. This return doesn’t need to be measured in dollars. In fact, measuring utility is the correct approach (for further reading: What is the economic value of happiness?).
So when is it reasonable to take on a loan? I believe we should consider the following 5 parameters before deciding:
#1 Is the situation or problem at hand temporary and focused?
Borrowing money should be a temporary solution to a temporary problem. If a situation or problem is here to stay then a change of lifestyle is required. Taking a loan will only worsen things as the problem does not disappear but the money does.
#2 Do you have a clear way out?
Be sure to identify the problem and the causes correctly before acting. If the causes can be treated and the problem solved by taking a loan then it just might be worth it. Make sure you’re not entering the slippery slope of debt by financing yourself with an endless chain of debt.
Have you way out mapped and charted. After taking the loan things might seem better off and the temptation to use the money in another way will grow. Be consistent and stick to the game plan.
#3 Are you sure it’s not luxuries you’re financing?
While we need luxuries to make life comfortable financing luxuries with the bank’s money will eventually leave you at an even more uncomfortable place. Remember that vacation you took 1.5 years ago and you’re still paying for? Is that comfortable? Wouldn’t you have rather saved up for 1 year and then take it carefree?
#4 Will the money be invested wisely?
Very basically speaking will the loan’s money yield higher return on investment? Again, we must not regard this in terms of money only. The best investments are in education and infrastructure for example. Invest in the future.
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