With the ongoing cost-of-living crisis placing pressure on household finances across the United Kingdom, the temptation to turn to credit has never been greater. Loans can serve as a useful tool for managing significant expenses, yet they also carry the potential to exacerbate financial strain if used unwisely.
The Smart Reasons to Consider a Loan
According to Obi Nnochiri, a chartered tax adviser and private client consultant at St. James’s Place, loans are not inherently problematic. The critical factor lies in their purpose. He argues that borrowing can be a sound financial decision when it funds an investment that delivers long-term value or enhances financial stability.
"Taking out a loan can make financial sense when it is used to fund something that provides long-term value or improves financial resilience," Nnochiri states. Examples he provides include purchasing a home, investing in education or professional skills, consolidating costly existing debts, or bridging a short-term cash flow gap with a definitive repayment strategy.
Sebrina McCullough, External Relations Director at Money Wellness, echoes this sentiment, noting a loan is justified if it "genuinely improves your situation in the long run." The peril, she warns, emerges when credit is used to mask a fundamental affordability issue. Her team frequently encounters individuals using loans merely to cover routine bills, a practice she identifies as a warning sign that borrowing will complicate, not alleviate, their problems.
Major Red Flags and Costly Traps
Financial professionals unanimously caution against using loans for day-to-day spending or non-essential purchases. Nnochiri advises that borrowing should generally be avoided for these purposes, especially if maintaining repayments would be difficult or reliant on anticipated future income.
"If borrowing is needed simply to keep up with regular bills, that can be a sign of deeper financial pressure," he explains. This scenario indicates an affordability gap that further debt cannot solve. McCullough singles out high-cost credit, such as payday loans, as a particular danger, describing them as "a major red flag" that can entrap individuals in a relentless cycle of borrowing.
A common mistake is focusing solely on the monthly repayment amount. Both experts stress the importance of considering the total cost of the loan. A lower monthly payment spread over a longer term often results in paying significantly more in interest overall. Factors like the interest rate, whether it is fixed or variable, and the loan term dramatically alter the final sum repaid.
Conducting a Realistic Affordability Check
Before applying for any credit, a thorough and honest budget assessment is essential. Nnochiri recommends starting with a detailed household budget that accounts for all outgoings, not just major bills. He also suggests stress-testing your finances by asking if repayments would remain manageable if interest rates rose or your income fell.
McCullough proposes using your budget as a resilience test. "Ask yourself whether you’d still cope with the repayments if your bills went up, your income dropped, or things didn’t go to plan," she advises. If the answer is negative, the loan is likely to create future stress. Relying on overtime, bonuses, or hoped-for promotions to service debt is considered a risky strategy.
For those already managing existing debts, the instinct to take on more credit should be resisted. Nnochiri suggests reviewing all current obligations and prioritising clearing the most expensive debts first. If repayments are becoming unmanageable, seeking early, free advice from an impartial service is crucial to prevent a short-term issue from escalating.
In summary, a loan can be a rational tool when it secures a lasting asset like a home or qualification, or restructures expensive debt into manageable payments. However, if it funds transient lifestyle expenses or relies on perfect circumstances for affordability, the risks are severe. Ultimately, debt should serve your long-term life goals. If it doesn't, pausing to seek expert guidance is the most prudent course of action.
