The Pitfalls of Easy Credit

Google search for finished basements reveals many nice ones

One of the women at work hopes to finish her basement by the end of the year. The only problem? She and her husband do not have the $30,000 or so it costs.

As a result, they've been discussing applying for a loan from their bank.

I'm paraphrasing a bit but, essentially, this is her reasoning.

It's too hard to save money to finish the basement.

Wifey and I would also like to finish our basement. Unlike my co-worker, we have the money. We could hire a contractor today and have the basement finished in a month or so (or however long it takes). We don't need to finish the basement this very moment though. Ideally, I don't want to sell our investments to finance the renovation. Our plan is to save the $30,000 outside our investments to pay for the finished basement.

We don't plan on going to a bank for a loan. Assuming an interest rate of 5% and making only interest payments, it would cost us $1,500 a year. Plus, eventually, we'll need to pay off the $30,000 principal.

As for my co-worker, I don't know why they feel borrowing $30,000 is a good idea to finish their basement. If they are having trouble saving money, they will have trouble paying off the debt. In the end, they will pay more than $30,000.

If they pay $500 a month towards this debt at 5% interest, it will take them 70 months (almost 6 years!) to pay off the debt and they will end up paying almost $4,600 in interest.

So why do it?

Probably because it's just so easy. Rather than find ways to save some extra money or cut back on the monthly expenses for a couple of years, you could just go the bank, sit down, get approved, and walk out with the money in one afternoon.

One theory as to why this is so easy is that banks are looking for new ways to make money. In this low interest rate environment, aside from raising their bank fees, they are also interested in loaning out money to anyone who asks for it.

Another theory is that Canadians rarely default on their loans. That makes us appear relatively low risk. Sure you'll need to provide income details and prove other financial circumstances..But, for the most part, we'll find a way to pay off the loan whether it takes years or dipping into other credit options.

Either way, if you want to be wealthy, getting a loan for a bank to pay for a finished basement will not help you get there.

Rather than add to your monthly expenses (you'll need to pay off the loan in monthly installments. Probably. I don't know as I've never had a loan aside from the mortgage), and in the process make a tight budget even tighter, cut down your expenses, save the difference, and build a small fortune to finance whatever you are aiming for. Whether it is a car, home renovations, or new gadget, you'll feel better knowing you worked hard to save the money first.

Back to the earlier example, in contrast, if my co-worker were to save $500 every month, they would have $30,000 in 60 months or 5 years! Assuming, they put the money in a savings account that pays 2% interest, they will have the money in 58 months!

Not only will they have the money after 58 months, but now they are spending $500 less forever.

That's money that will go into savings and towards building your wealth.