Managing Your Debt.
It is rare to find people who has never taken a loan in their life. Taking on a loan, managing it and paying back the loan is all part and parcel of life. It helps develop your sense of responsibility in using the loan money and responsibility paying your loan.
People usually get into debt crisis when they take on too much loan. These people stretched their cash flow to the limit and when something unfortunate happens to their cash flow, then they realize they could not meet all their repayments.
There are 2 main issues you need to look into when deciding to take a loan or not. You need to know the purpose of the loan and the amount of loan.
Why do you need the loan?
There are only 2 types of loans. Good Loans and Bad Loans.
Good Loans are loans which you take on to buy appreciating or income generating assets. Some examples are properties, stocks precious metals such as gold and so on.
As time goes by, these assets will rise in value but your loan will not rise in value. So when you sell your asset to pay off your loan, you will still have some money leftover. In summary, the asset itself will be able to pay off the loan that you had taken to buy this asset in the first place.
Example: Good loan.
You buy a house for $100,000 by using $5,000 from your savings and $95,000 from a loan or mortgage from a bank. Every month you pay your mortgage installment.
5 years later, your house is worth $140,000 and after paying installment for 5 years, your outstanding mortgage is $90,000. If you want to, you could sell your house and pay off the mortgage and still have $50,000 leftover.
Bad Loans are loans which you take on to buy depreciating assets or entertainment. Some examples are cars, home theater systems, holiday packages, weddings, gifts and so on.
Example: Bad loan.
You buy a car for $20,000 by using $1,000 from your savings and $19,000 from a bank loan. You pay your loan installment every month.
2 years later, your car is worth $16,000 and your outstanding loan is $17,000. In this case even if you sell your car you will not have enough money to pay off your loan.
Therefore before you agree to take a loan, you must be sure whether it is a Good Loan or Bad Loan and the reasons you are taking the loan for.
As a general guide, you should only take on Good Loans. Taking on Bad Loans will only set you back in terms of personal net worth and you'd be better off if you did not take the Bad Loan in the first place.
How much loan should you take?
By taking on the maximum loan limit you can afford, you run the risk of not being able to meet your monthly payments when the interest rates shoots up or when something unfortunate happens to your income streams. Taking on a lesser amount of loan will ease your monthly cash flow but the loan may not be enough for you to use. Therefore, the balance is somewhere in between.
Some questions to ponder are:
- If an unfortunate event happens to you, will your family members have the financial capacity to meet the repayments? If no, then you should consider buying insurance or lowering the loan amount. For example you plan to take out a loan from your credit card to pay for the state of the art home theater systems. Then you could save money for a few more months thus lowering the amount of loan you need to take out on your credit card. Mind you this is a Bad Loan.
- If an unfortunate even happens to your income streams, do you have other means to meet the monthly repayments? If yes, are they enough to cover your repayments?
You must feel comfortable with your cash flow. The monthly loan payments should be manageable. Then you will not worry about your loan when you sleep.