USING the Banking Association of South Africa’s definition, a loan is a sum of money borrowed from a lender to assist for certain planned or unplanned events.
The borrower is then required to pay back the money, including the interest charged over a stipulated period of time.
Essentially, the interest payment is the cost of borrowing to the borrower and it is determined by the interest rate.
Several times I have had informal discussions with different colleagues on the subject of loans and borrowing.
It is attention-grabbing to note that a significant number of them think that loans are not good and should not be encouraged because they leave people in debt and vulnerable to the lender.
This argument was once advanced so strongly such that I couldn’t help it but imagine that the speakers either had a bad experience with a loan, or they witnessed someone close to them who became heavily indebted.
Many of us can point at either one or two cases of people who borrowed and had to pay through their nose.
However, do these experiences or the incidences we witnessed justify the notion that loans are bad?
From the borrower’s point of view, there is no such thing as a bad loan.
There can only be a bad use or bad plan for a loan, as quite often, people borrow to finance consumption activities.
This is technically not a good reason for getting a loan.
They borrow to buy expensive vehicles, finance events and pay for holiday trips or to fund improperly appraised investment plans.
The result is an inevitable reduction in disposable income and a burden of making unpleasant periodic payments to your lender.
What better excuse than to blame it on the loan?
Simply put, if you borrow funds at a given interest rate and invest the funds in a project that will pay you a return which is significantly higher than the sum of the principle and interest
payment, it implies that you will be able to pay the loan and still remain with the difference between the return and the amount you are paying.
This is your gain.
In this case you would have created value in that you are now better off than you were before you borrowed.
A practical example would be getting a K200,000 loan costing K2,200 every month in principal plus interest payment for four years.
If you invest in constructing a house which will give you K3,000 rental payments every month, you would be definitely better off than you were before the loan.
Ignoring the time value of money, you would have gained an extra K800 per month which you did not have before the loan.
And after the four years, you would be K3,000 richer every month than you were before the loan and you would be owning an asset of higher value.
Surely that doesn’t sound like a burden.
A number of financially successful individuals use loans to their advantage in this manner.
When isolated, a loan can neither be good nor bad.
It takes on the form of the plan or purpose for which it is borrowed and the borrower’s relative capacity to repay.
It is, therefore, financially prudent for the borrower to ask themselves the following few critical questions before approaching a financial institution to borrow funds; Why do I want to get a loan?
How much do I intend to borrow? How much can I afford? How is my budget and monthly cash flows?
How does the loan fit into my long-term financial objectives? For how long will I be repaying the loan and at what rate? Is the interest rate fixed or variable?
If I am investing, will the returns from the loan be enough to cover the loan repayments?
What is the long-term impact of the loan on my future financial position? Sincere responses to these questions can help you make an informed decision.
Bank loans are advantageous primarily because they attract less interest rate compared to overdrafts and credit cards.
Personal loans offer the luxury of flexibility of use, quick availability, minimal documentation required and no collateral requirements (in most cases).
Loans also offer you immediate access to funds you may need for investment which you may be incapable of raising otherwise.
The two major disadvantages of loans are the required discipline of repaying the loan over a long period of time and the unpredictability of loan repayment amounts in the case where the interest rate is variable.
If applied astutely, loans have a capacity of augmenting your financial position and paving way for your financial freedom.
The opposite is also true that inappropriate use of loans leads to a burdensome debt trap.
Be financially smart by planning your finances incisively.