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Not all Debt is bad

People need to borrow money for many reasons. Some might borrow to respond to an unexpected emergency, purchase an item for which they do not have enough money at the time of purchase, or to invest in their own businesses.

Not all debt is bad: A loan provides you with a lump sum of money that might be difficult to obtain otherwise. It enables you to take advantage of business opportunities, respond to emergencies, make home repairs or purchase something you need.

But borrowing money can be expensive and carries obligations to repay on time. For these reasons, taking a loan is not the same as using your own money that you may have through wages, business profits or savings. The chart below outlines the advantages and disadvantages of taking a loan.

 

 

Taking a Loan

Using Your Own Money

Advantages

You gain access to more money than you have in savings

You get money quickly when you need it for emergencies

You avoid the costs of borrowing.

You are free to use your money as you wish

You face less risk when you finance your business growth in smaller increments based on what you can afford to invest

You avoid the obligation of future loan repayments

Disadvantages

You bear the cost of borrowing (fees or time required to apply)

You are responsible for repaying your loan on time and face penalties for late payment.

You have limited access to the amount of capital you require.

Your business grows more slowly.

You have limited ability to respond to opportunities.

Risks

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 in Pakistan. Yet, loans must be repaid, regardless. 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.

 

Use of Debt

Good Debt

Bad Debt

Purchasing an Asset or Consumer Durable

The asset or goods purchased outlast the time it takes to pay off the lender.

The income earned from the asset exceeds 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 increase 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.

 

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 like 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.

Loans are advantageous for those people who require a larger sum of money than they already have, in order to invest in an asset, respond to an unexpected emergency or to consume or purchase required items. Borrowing allows you to access money more quickly than if you rely on your ability to save little by little.