Borrowing money: 3 tips to make smart choices

Not all debts will help you. Even a debt that’s good for one person might be bad for someone else. Learning to tell the difference could help you make sure your debt is a tool you use for reaching a goal, not a burden that prevents you from getting ahead.

Let’s explore a few quick questions to ask yourself before you decide to take on new debt. 

1. How much will it cost to borrow?

Any time you borrow money, there’s a cost. Most types of debt charge interest, for example. There may be other charges, too. Some credit cards have annual fees. Mortgages generally carry closing costs. In fact, one key way to tell good debt from bad debt is the cost. 

In some cases, debt increases the cost of the thing you’re borrowing for. That’s a price many of us are willing to pay, for example, to buy a home. But it wouldn’t make sense if you’re borrowing for a luxury vacation that’s too expensive for your budget.

Debt could also lower the cost of something you have. Namely other (more expensive) debt. If you qualify for a debt consolidation loan at a lower interest rate than what you’re currently paying, you could come out ahead by taking on the new debt, even if you pay fees and interest. 

You can evaluate the cost of the debt within the context of your situation to decide whether it’s a good price. 

How to calculate your borrowing costs

First, use an online loan calculator. If you enter the loan amount, the loan term, and interest rate, the calculator should tell you the payment amount and total interest charges.

Now, find out the loan fees. Talk to a lender who can check your interest rate and fees by doing a soft credit check that doesn’t hurt your credit standing. 

Add the fees to the total amount repaid (including interest) and that’s the total cost of the loan. The calculator might have a field where you can enter the fees so you don’t have to do the final calculation manually.

For example, let’s say you want to borrow $50,000 to remodel your kitchen. You take out a three-year personal loan for home improvements with an 18.5% interest rate. 

Your monthly payment will be $1,783 per month, and by the time you’re done paying it all off, you’ll have repaid $64,175. So far, your cost is $64,175.

If your lender charges an origination fee, add that cost. Let’s say this loan comes with a 4% origination fee, or $3,495. Your total cost is $67,670. 

2. What are your opportunity costs?

Anytime you make a choice for something—anything at all—you’re also making a choice to not have something else. If you decide on tacos for dinner, you’re deciding not to have chicken wings.  

Opportunity costs sound limiting, but they don’t have to be. Maybe you don’t care about chicken wings. Even if you have to choose between two things you want, knowing your opportunity costs is a great way to make sure you get the thing that’s more important to you. 

When you take on a new debt, you’ll need to pay it off. The money you spend on monthly payments won’t be available for other expenses. That’s why it’s a good idea to pause and consider other uses for that money before you decide to borrow. By doing so, you can better align your short-term wants with your long-term goals. 

Let’s go back to that $10,000 loan and consider an opportunity you’d give up—saving. You could set aside $327 in a high-yield savings account every month. If the interest rate is 4%, you’d end up with $13,249 in the account after three years. (You’d hit the $10,000 goal in about 29 months.) This opportunity depends on whether the home improvements can wait, and whether you have the discipline to add the $327 to your account each month.

3. Have you considered alternatives?

Many debts are optional. In other words, they’re just one choice out of several you could make. Before you apply for a new credit account, consider other ways to cover the expense. Depending on why you need the money, you could:

• Ask for a payment plan.

• Sell things to raise cash.

• Take on extra shifts at work or start a side hustle.

• Go through your budget to cut unnecessary expenses.

• Look for grant money or charity funds.

• Postpone your purchase and create a savings plan with automatic transfers.

What’s next?

Knowledge is power when it comes to wise financial choices, especially when it comes to distinguishing good debt from bad debt for your own wallet. Many strategies could help you put that know-how to good use:

• Find a budget routine that works for you.

• Create a debt payoff plan for debt you already have.

• Save up an emergency fund so you don’t need to borrow as much.

• Put up reminders of long-term financial goals in highly visible places like your fridge door.