Tight on Cash? The advantages and disadvantages of borrowing money

Whether you need to pay for tuition to advance your academic future, need to pay off emergency expenses for home improvements, or are considering a new vehicle, there are numerous reasons why someone may want to consider borrowing money.

While personal loans can help in situations like these, before applying for a loan, it's important to weigh the advantages and disadvantages of doing so regardless of your current financial situation.

To learn more about the advantages and disadvantages of personal loans, browse through our comprehensive loan guide below.

Advantages of bank loans

Depending on your borrowing needs, personal loans can be incredibly advantageous in many situations. Here are some of the benefits you can experience when taking out loans:

Improve your credit score & credit history

When you take out a personal loan, you'll be responsible for making a monthly payment back to your lender until your principal balance is paid off with interest. Each time you make a monthly payment on time, your lender will send this information to a credit bureau, and over time, your credit scores will increase.

Personal loans for credit building is a strategic method used for long-term financial planning should you wish to take out other loans in the future with competitive interest rates, be approved for a mortgage, and more, which will contribute to your overall financial health.

One lump sum payment

Once you've been approved for your personal loan, your lender will transfer the money directly into your bank account in one lump sum payment, making it easier for you to pay off large expenses with ease. Depending on the repayment terms of your personal loan, you may be given a grace period before you'll need to begin making your regular monthly payments.

An unsecured loan means no collateral

Collateral is any asset with a high value, such as your home or car. Unlike secured loans, most personal loans are unsecured loans, meaning you will not need to forfeit any collateral to your lender if you are unable to meet your repayment terms.

In some cases, this can give borrowers a bit more peace of mind. Just remember that if you are unable to make your loan payments on time and fail to pay back the principal amount with interest by the end of your loan term, your credit score can suffer greatly.

Lower interest rates

Compared to other types of loans and virtual credit cards offered by financial institutions and credit unions, personal loans tend to have better interest rates. And, if you have a good credit score, to begin with, you can potentially negotiate a lower interest rate with your borrower, which will decrease what you owe monthly and altogether.

Most personal loans have a fixed interest rate

Unlike home equity loans and lines of credit, personal bank loans tend to have a fixed interest rate. This means that you'll know exactly what your monthly payments will be. You will also be able to protect yourself from rising interest rates and effectively meet your financial goals with more confidence.

Potential tax benefits

In some scenarios, you could experience tax benefits when taking out specific bank loans. For example, if you're a business owner and are thinking about taking out a business loan, you can deduct the interest you pay and list it as a business expense on your income tax.

Flexible spending for your financial needs

With so many loan options available to Canadians, whether it be a personal loan, student loan, home equity loan, or others, getting a bank loan means you can use the extra money to fund your financial goals and is highly customizable to meet your unique financial circumstances.

Disadvantages of bank loans

While there are numerous advantages to bank loans, there are also risks you need to be aware of before applying for one:

It will impact your debt-to-income ratio

Taking on a bank loan could end up negatively impacting your debt-to-income ratio (DTI). This ratio essentially measures how much of your monthly income is put toward your debts. Many lenders use this ratio to determine your creditworthiness and whether your financial capabilities will allow you to take out more debt.

As a general rule of thumb, your debt-to-income ratio should not be above 30%. Therefore, if you already have a higher ratio, it could impact your ability to take on another bank loan in the future.

It could worsen your financial situation and damage your credit scores

Another disadvantage to taking our bank loans is that it could seriously impact your financial well-being. Taking on more unnecessary debt than you can handle could lead to the inability to make your monthly repayments, which in turn will continue to increase the overall outstanding balance you need to pay back to your lender.

Don't have a strong credit score? You could face high interest rates

The reality is that you may not be able to get a personal loan with bad credit. The lower your credit score is, the more risk you pose to institutions that lend money. If, by chance, you do get approved, you can expect shorter loan terms, more interest, and a tougher approval process.

Tip: Understanding your credit report and getting a free credit score check is one of the ways you can continuously monitor your ongoing credit score, which can help you avoid getting yourself into a less-than-ideal financial situation in the future.

Repayment terms may not be flexible

As soon as you sign your personal loan contract and receive your bank loan amount into your account, you're locked in until the repayment term is over. In some scenarios, you may even face prepayment penalties if you try to pay off your outstanding balance quicker than what has been agreed upon with your lender.

Is a personal loan right for you?

Before applying for a personal loan or other type of loan for that matter, take a look at these factors we've listed below to see whether or not a bank loan is right for your current circumstances:

You've got a good credit score

To secure a lower interest rate, having a good credit score is a must. It can also help you increase your loan amount without putting collateral down, which you would otherwise risk losing if you were unable to pay back your principal loan amount with interest. Ultimately, if you want to build your credit with a personal loan and are already in a healthy financial spot, it may be a good option for you moving forward.

If you're interested in improving your score, you can build your credit with KOHO to help manage your current plans for spending and saving.

Your existing debt obligations are low

Next, you'll want to take a look at your current debt and determine whether adding additional bank loans is a good idea, given your current debt-to-income ratio. If adding more debt increases this ratio beyond 30%, the additional debt may not be worth it.

In contrast, if you don't have much debt to begin with, looking at loan options as a way of funding a big purchase may be worthwhile if you're responsible enough to stay on top of your loan obligations.

You've got a steady income

Lastly, having a steady employment income will also play a big role in whether taking our personal loans is a smart financial decision. Having steady employment and regular paycheques will help give you peace of mind, knowing that you can avoid interest charges from late payments.

On the other hand, someone who has self-employment with an irregular paycheque may want to avoid borrowing money through bank loans.

What to consider when looking for when applying for loans in Canada

Before applying for your bank loans, you'll want to look at more than one financing option, as it can help you find the best deal out there. Here's what you need to keep an eye out for:

Interest rates

Shop around and compare interest rates from multiple lenders if possible. Securing a lower interest rate will lower your overall costs when borrowing funds through your bank loans. Lenders use different parameters when determining interest rates they offer to potential customers, which is why shopping around is highly recommended.

Loan terms

You will also want to look at the repayment terms offered with specific bank loans. These terms should also include the frequency of your payments and how long you have to pay back the loan. While longer-term loans can decrease your monthly payment amount, it may lead to more interest paid over time, which is something you'll want to avoid if you can afford to do so.

Additional fees or charges

Another thing to keep in mind is the additional fees associated with taking out personal loans. Common fees include origination fees, prepayment penalties, and processing fees, which could impact how much it will cost you to pay back your bank loans in the end.

Secured or unsecured loans

Lastly, pay attention to secured loans and unsecured loans and know what it means to have secured vs unsecured debt. Secured loans will require borrowers to offer collateral before they are approved for their loans. Because of this, there is more of a risk that you could be forfeiting your assets to your bank if you are unable to meet the terms of your loan agreement. If secured loans are the only type of bank loan you qualify for, you may want to consider other options depending on your current financial circumstances.

Look for an alternative

Bank loans aren't for everyone, and that's okay. Luckily, there are some alternatives that you can look into if you're still looking for extra cash:

Credit cards

When it comes to alternatives, you may want to look into opening another credit card or asking your credit card company to increase your credit limit. Keep in mind that while this may seem like a quick fix, credit card interest tends to be higher than the interest you would see with a bank loan.

And if you have an overspending habit, credit card debt can pile up easily, putting you more in a financially risky spot than before.

Personal line of credit

A personal line of credit is a different type of loan that works similarly to a credit card. However, instead of getting one payment from your bank once your approval goes through, you'll be able to access credit on an ongoing basis as you need it, up to your credit limit. Another noticeable difference with credit lines is that you only need to pay interest on the money you borrow rather than the amount you've been approved for. Just keep in mind that personal lines of credit usually have variable interest rates, which means your monthly interest charges can vary.

Looking to borrow money? Contact KOHO today!

Deciding whether or not to take out a personal loan can be a daunting process, but with the help of KOHO, you can make financial decisions with confidence.

Whether you want to learn more about the impact of low interest rates, browse other financial topics in our resource hub, or open a high-interest savings account with overdraft protection coverage, KOHO gives you the flexibility and freedom to do so from wherever you are in Canada.