My finances, my projects, my life
August 5, 2020

Loans: the right approach when you need one (1/3)

Studying abroad, buying an apartment or new car, financing your dream vacation – we all have good reasons for taking out a loan. However, loans are not to be taken lightly. In a series of three articles, myLIFE sets out the right approach to this topic. In this first article, we’ll look into the first key question to ask yourself: do you really need to borrow money?

Financial burden and mental load

“It costs money to borrow money.” If, like 53% of Luxembourg households, you have at least one loan to repay, you have likely heard this warning before. A loan costs money, and sometimes a lot of it! So, even though many people have loans, you should never take one out lightly.

In addition to the financial burden of debt, you also need to take into account the mental load that many of us experience when we have to decide whether to take out a loan. We feel this way because there are so many factors to take into account, including our personal preferences, which may be contradictory, and the sheer array of products on offer. All of this can be very confusing.

Since the subprime mortgage crisis, European authorities have strengthened the laws that protect consumers. They now require financial institutions to provide more detailed information on the various costs, to warn consumers more systematically that it costs money to borrow money, and to stress the fact that all loans must be paid back.

This increased transparency is good for us consumers, but it also has a negative effect: instead of simplifying the decision-making process, the large quantity of information available ends up confusing most borrowers. There is so much information out there that they can’t figure out how to make a rational decision.

Even the financially educated tend to make decisions based more on their emotions than reason.

Even the financially educated tend to make decisions based more on their emotions than reason. Especially when it comes to their personal finances. Why? Simply because it is difficult to imagine the future and judge whether today’s commitment will become tomorrow’s burden.

In addition to the legal obligation to assess the risks of a person who wants to take out a loan in a standardised way, there are other individual vulnerabilities that banks have a hard time identifying if the person isn’t even aware of them themselves. In order to ensure that the loan has the desired benefits and does not become a burden, you need to be clear about your situation and preferences.

Before asking your banker for a loan, we suggest evaluating your own needs in three steps. This will help you identify cognitive biases that may influence, or even distort, your decision-making.

The first step is to objectively evaluate your need for a loan. The second step will help you decide between the various loans on offer. The third step will teach you how to judge your future ability to pay back the loan.

Step 1: will the financing you want now meet your future needs?

Is the loan’s purpose really worth the total cost, taking into account your life plan? Most of us never ask ourselves this question. Does the “It costs money to borrow money” warning work? Behavioural studies have shown that it does not. This warning goes in one ear and out the other. People understand it, but don’t really digest it.

This type of warning requires us to think about the future and a future cost, whereas most of us are focused on the present. And our desire to finance a good or service that we think we need right now often wins out over the future.

Free yourself from present bias

In behavioural science, giving too much weight to what we see as an immediate necessity is called “present bias”. Our brains are so obsessed by the present that this can prevent us from clearly and objectively evaluating our actual needs.

There are, of course, completely legitimate and necessary reasons to take out a loan: long-term study abroad, real estate or a new car for example. Sometimes, however, the desired object is not something we genuinely need. Or the need may be financed in a different way.

For example, do you really need to take out a loan to buy new hi-fi equipment? Couldn’t you just save a little every month and hold out a bit longer with your current equipment? Or why not use money from your savings account that isn’t making you any money right now and may even be affected by negative interest rates? Why not invest your easy-access cash in this project if it’s really that important to you?

It is important to think in terms of needs instead of wants to get yourself out of the cycle of instant gratification.

It is important to think in terms of needs instead of wants to get yourself out of the cycle of instant gratification. We can fixate so strongly on what we want right now that it limits our ability to think rationally. Ask your loved ones or a financial advisor for advice before making a decision.

Don’t turn a present emergency into a future burden

Emergencies that arise out of nowhere can unfortunately encourage us to focus on the short term. For example, a large unplanned expense can force you to look for a quick solution and choose an easily accessible loan. These situations and their potentially negative consequences take up so much space in our brains that we end up making less-than-optimal choices and neglecting possible alternatives.

There is no miracle cure besides making sure that we stay attentive and consider all of our options. Don’t put your future finances at risk with short-term decisions that have far-reaching consequences. Once again, your banker is there to help you make financial decisions.

Be realistic about self-control

Don’t overestimate your ability to manage your budget and balance day-to-day expenses with loan payments. To make good choices, be honest with yourself and ask yourself if you’re lacking in self-control. If the answer is yes, you are more likely to be tempted by immediate gratification and compulsive shopping than others.

If that is the case, then you need to make sure that you aren’t compromising your financial future by taking out too much consumer credit. Try setting long-term goals like “keeping my finances balanced as long as possible while saving a little” so that you can build up a deposit to buy real estate. You can also consider using a financial tool that will help you save enough money to finance what you want without using credit. A smart budget is easy to make.

If you completed this first step, you have successfully separated want from need. Do you really need to take out a loan to finance what you want? If the answer is yes, it is time to head to step two: which kind of loan should you choose?