Understanding loans: What makes a good loan, and how to compare loans

The goal of this lesson is to help users understand the true cost of loans, the potential risks associated with borrowing, and how to make informed borrowing decisions. By learning how interest rates work, understanding the signs of over-indebtedness, and distinguishing between good and bad loans, users will be equipped to take control of their financial future and make informed decisions when borrowing.

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A loan is a tool

When used correctly, it could increase your income and change your life for the better. However, when used without consideration, it can cause stress and problems that could impact your future. Many people take loans without fully understanding how much they will need to repay, leading to unexpected financial burdens and difficulties.

Almost everyone will need to borrow money at some point—whether it’s taking out a student loan, financing a car, getting a mortgage for a home, or using a credit card. Loans can be essential financial tools, but if mismanaged, they can also lead to financial trouble. In this chapter, we provide a detailed overview of loans: the common types of loans, how interest works on loans (fixed vs variable rates), how to compare loan offers, the risks of overleveraging (taking on too much debt), and best practices for borrowing.

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Informed borrowing

To make informed borrowing decisions, it's essential to understand how interest rates work and to calculate the full cost of a loan before accepting it. Using an interest calculator or repayment table helps visualize the total amount due, including any fees or penalties.

You can also calculate by yourself, but if you have compound interest, it could be difficult. To calculate how much you will need to repay on a loan, you need to consider the loan amount (principal), the interest rate, and the repayment period.

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Calculating a loan with simple interest

Interest = principal × annual interest rate × time (in years)
To calculate the total amount you need to repay (principal + interest), use the formula:
Total amount = principal + interest

Example‍

If you take out a loan of GHS 10,000 with an interest rate of 5% for 2 years:
Interest = GHS 10,000 × 5% × 2 = GHS 1,000
Total amount = GHS 10,000 + GHS 1,000 = GHS 11,000

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Calculating a loan with compound interest

With compound interest, the interest is calculated not only on the principal but also on the interest that has accumulated over time.
The formula for compound interest is:
Total amount = principal × (1 + annual interest rate) ^ time

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Example
If you take out a loan of GHS 10,000 with compound interest at 5% for 2 years:
Total amount = GHS 10,000 × (1 + 0.05) ^ 2 = GHS 10,000 × 1.1025 = GHS 11,025

The total amount is GHS 11,025.

Smart borrowing practices include borrowing only when necessary (such as for education, business, or medical needs) and repaying on time to avoid additional charges. Loans are not free money—always ask yourself: how much will I pay back in total?

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Avoiding over-indebtedness

Avoiding over-indebtedness is very important. This occurs when your loan payments consume a disproportionate amount of your income. Warning signs include borrowing to repay existing debt, skipping payments, or running out of money before the end of the month.

A general rule: monthly loan repayments should not exceed 30% of your monthly income. Before taking any loan, calculate your repayment ability based on your budget. Managing your spending, resisting pressure from others to borrow, and planning help you stay in control.

Failure to repay loans regularly creates a negative credit history. Lenders use this history to decide whether to offer loans in the future. If someone has a poor repayment record, it becomes more difficult to access formal credit when it is truly needed. This can push individuals toward expensive informal loans or leave them unable to invest in their businesses or families.

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Managing credit

Credit is a vital component of financial life, enabling individuals to borrow money for purchases or investments and repay it over time. Understanding how credit works, using it responsibly, and building and maintaining a good credit history are essential for achieving financial stability.

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Key components of credit

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Credit score

A number that shows your creditworthiness. A high score helps you get better interest rates, while a low score makes borrowing more complex or more expensive. A typical credit score ranges from 300–850.

Credit reports

These show your credit history, including all your loans, repayments, and missed payments. You should review your credit report regularly to ensure everything is accurate.

Credit utilization

This refers to the percentage of your total credit limit that you're using. If you owe GHS 1,000 on a credit card with a GHS 5,000 limit, your utilization is 20%. It's good to keep this under 30%.

Managing credit responsibly

• Always pay your loans and credit cards on time
  
  
• Avoid using too much of your available credit
  
  
• Check your credit reports often for mistakes
  
  
• Start small with borrowing and build your credit slowly
  
  

According to the World Bank, “a lack of credit history or a negative repayment pattern can significantly reduce access to affordable loans in the future.”

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How to determine if a loan is right for you

Not all loans are the same. A good loan helps you grow—like one used to start or expand a business, invest in farming, or pay for education. A bad loan covers short-term wants, like buying a luxury phone or throwing a party.

Before taking out any loan, ask yourself:

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Will this loan help increase my income?

If the loan is for something that will bring more income (like school or business), it may be a good idea.

Do I have a clear repayment plan?‍

You must know how much you will pay back each month and have a plan to manage it.

Can I avoid the expense or delay it until I can afford it?‍

If it’s not urgent, it’s better to save for it than to borrow.

Communicate early if issues come up

‍If you can’t make a payment, talk to your lender early. They may be able to delay the payment or change your plan. Ignoring the problem makes things worse.

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Types of loans

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Mortgage loans

Used to buy a home. Long-term and usually lower interest, because the house is used as security.

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Auto loans

Used to buy a car. The car is the collateral. Be careful not to owe more than the car is worth.

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Student loans

Used for school. They can be helpful if you have a plan to repay them after you finish school.

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Personal loans

Used for things like emergencies, school fees, or medical bills. These loans are not tied to property and have higher interest.

You might also find our article on The hidden cost of not paying your loan helpful.

For related tips, take a look at What is Compound Interest?.

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Credit cards

Let you borrow small amounts repeatedly. If you don’t pay the full amount each month, interest adds up quickly.

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Home equity loans or lines of credit

If you own a home, you can borrow against its value. Lower interest, but risky if you fail to repay.

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Microfinance and short-term loans

These are good for people without access to banks. They're often used for small businesses or urgent needs. Repay them on time to avoid extra charges.

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Pawn shop or title loans

You give something valuable as security. If you can’t repay, you lose it. Only use if you really have no other option.

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Business loans

If you run a small business, this loan can help you buy inventory or equipment. Always read the terms.

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Comparing loans – what to look for

When shopping for a loan, consider:

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Interest Rate (and APR)

A lower rate means you pay less interest over time.

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Term (Length of Loan)

Shorter loans typically result in higher monthly payments but lower interest overall.

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Monthly Payment

Ensure the payment fits your budget.

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Fees and Penalties

Check for origination fees, prepayment penalties, and late fees.

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Secured vs. Unsecured

Secured loans use collateral, while unsecured loans rely on your creditworthiness.

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Creditor Reputation

Borrow from reputable institutions.

Risks of over leveraging (too much debt)

Over leveraging happens when you borrow more than you can repay. It leads to stress, more interest, and a bad credit score. Only borrow what you can manage, even if times get tough.

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Final thoughts

Borrowing can help you reach your goals—like owning a home, paying school fees, or growing a business. But don’t borrow without a plan. Understand the costs. Stay within your budget. Pay on time.

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As the saying goes, “debt is a useful servant but a cruel master.” Use loans wisely, stay in control, and build a better financial future. Explore how you can apply for a good loan with Fido today.