Risks associated with borrowing

For every borrower, debt is a risk. If you can’t repay your loan, there will be consequences!  Even with careful planning, you may have problems making loan payments. Many unplanned events can turn this risk into reality, such as the following:

  • When your income is interrupted due to illness or necessary absence
  • When the investment of the loan results in a loss
  • When your household and business expenses are greater than your income
  • When unexpected events create an urgent demand for cash (e.g. to pay doctors’ expenses, funeral costs, etc).

Situations like these are common among the poor. Yet, loans must be repaid, regardless of the situation. If you face difficulties making your loan payments, what are your options?

To get the money for loan payments, you might need to reduce your spending or sell something of value.  You can ask your friends and relatives to help you, but there is a risk that you will eventually “use up” their goodwill towards you.

If you fail to pay altogether or default on your loan, what are the consequences?  You may lose access to sources of credit in the future.  You may strain relationships with other members of your credit group; you might suffer humiliation in the community and lose the goodwill of your friends and family.  Defaulting on a loan may damage your confidence and self-esteem.

Borrow wisely

The risks that come with taking a loan should make you think carefully about when and how much to borrow. Loans can open new doors, but you need to know when taking a loan is a wise decision. Good uses of loan capital include the following:

  • Purchasing inputs in bulk at a lower price that will increase profits
  • Financing productive assets such as machines that help you improve productivity, i.e., a water pump that enables an additional harvest or food-processing equipment that adds value to a crop.
  • Purchasing an asset that makes a new business possible, such as a cell phone or a refrigerator

Simply put, borrowing is good when it helps you gain financially and bad when it becomes a financial burden.

Use of the Debt Good Debt Bad Debt
Purchasing an asset or consumables The asset or goods purchased outlast the time it takes to pay off the lender. The income earned from the asset exceeds the cost of the loan. Debt is still owed after the item is consumed or the income earned from the asset is less than the cost of the loan.
Working capital The loan makes it possible to pursue a business opportunity that is profitable enough to repay the loan and have something left.  The loan helps you save money on inputs or inventory and thus increases your earnings from the final product. You cannot earn enough to repay the loan.

You have other less-costly sources of financing.

You cannot get the loan in time to take full advantage of a specific opportunity.

Emergency loan The loan helps you solve an immediate problem without undue hardship. The loan terms are too costly, or cannot be adjusted to your ability to repay.

 

To pay back your loan, you have to make the money work. Borrow for productive investments such as buying a piece of land where you can grow something or increasing your business. Payback the loan and maybe borrow more later if it is necessary. Use loans wisely and never rush into borrowing. Think twice before borrowing for luxuries or things that lose value (e.g. car, furniture, clothes, etc) except if they are meant to boost your income.

The Costs of Borrowing:

The main cost associated with a loan is the interest charged for the use of the money. This is usually calculated as a percentage of the total loan amount, and you typically pay it in monthly instalments as part of your loan payment.  In addition, many lenders also charge administrative fees which you usually pay once, when you take the loan. Interest and fees are charges that you pay directly to the lender. These “direct costs” are usually cash payments.

However, there are other expenses associated with borrowing that may not be so obvious. Sometimes applying for and taking a loan forces you to spend money for transportation to attend meetings or go to the bank to fill out application forms.  These activities may take you away from your business, forcing you to close it or hire someone to “mind the store” while you are away. Although these additional “indirect costs” may not be part of the cash loan payment, they are real and should be considered when choosing a lender.

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