To the fortunate minority of people that don’t have consumer debt, congratulations on staying prudent and cautious with your money. Aggregate household debt reached close to $14 trillion in 2019 and is set to continue rising despite lower rates of unemployment and the increase in wages. This phenomenon has partly been due to the boom in the housing market that has attracted new mortgage borrowers. In contrast, the rate of application for student loans, as well as credit card and some online car loans are growing steadily, revealing that many households who aren’t prepared will soon take a hit from the financial strain.
There are multiple situations in which it is appropriate to borrow money. But while it is important to distinguish between “good” and “bad” debt, the ability to abide by several specific rules when borrowing money is the most important aspect that determines whether the debt will be effectively managed or not.
Here are some simple yet important rules when it comes to borrowing to finance your daily expenses.
The don’ts of borrowing
Don’t borrow if you’re already caught in deep debt
Unfortunately, debt cannot be solved with more debt. Instead, you need to reduce your losses and your expenses before your debt starts to accumulate and grow out of control. How do you identify debt that’s out of control? By simply calculating your debt-to-income ratio—a comparison of the sum of your monthly income to your monthly debt payment. Exceeding 43% is cause for worry and a sign that you simply cannot afford to start another debt.
Don’t opt for variable rate loans to finance your car notes, mortgages, student loans, etc.
Sure, the small benefits that you initially enjoy with variable rate loans might make this option sound attractive, but the risks that come with it are extremely dangerous. Recall the credit and subprime mortgage crisis that occurred in 2007-2008: borrowers were drawn to the ARMs (adjustable rate mortgages) that had interest rates that started small but grew rapidly thereafter to set off defaults. The wisest option is to always be informed of how much interest one has to pay over the course of the loan and to be clear on your payments due monthly. The simplest way to achieve this is through fixed-rate loans.
Don’t borrow without knowing the full terms and conditions
Without reading the fine print in the terms of your loans, you will never know that the terms of repayment or interest may be less favorable than you think. Options for making changes to the debt agreement could be restricted, liens could be imposed on your property—these are all possible terms that you might miss out on if you don’t take the time to read the terms and understand it thoroughly. Make sure that you clarify any doubts with your borrower and if you still lack clarification, contact the CFPB or a professional attorney or accountant. (I have personally fallen victim to having liens placed on my property and regret not taking my own advice sooner.)
Don’t borrow more than you can afford to
This has probably been said countless times, yet the same mistake has gotten millions of Americans into deep financial trouble every year. Before borrowing, make sure you are absolutely sure that you will be able to pay off your debt fully. This includes being certain that you will have a regular income to pay off the loan balance consistently, and that you are also able to cut on your expenses to afford the loan. This is also why a mortgage or any long-term loan is an extremely heavy undertaking. The wisest decision you can make is to borrow less than you can afford.
The do’s of borrowing
Apart from taking precautions when it comes to taking a loan, there are simple measures to make borrowing an efficient and safe process. The following tips will show you how to reduce certain risks involving repayment during the course of the loan, as well as how to boost your credit in the long term.
Do negotiate with your lenders for the lowest possible interest rates
No matter the kind of debt you’re planning to take on, be sure to look for the lowest interest rates possible. This will help you pay less over the course of the loan and in turn, bear lower risks of being overdue on payment should you face tougher financial circumstances. Do comparison shopping to see the various interest rates and ask if there are available forms of reduction like letting repayments be automatically deducted. If you’ve consistently paid on time for a few months, you may also request interest rate reductions.
Do pay more than the minimum required payments; this reduces interest by significant amounts over the life of the loan
This step involves a simple trick: paying bi-weekly rather than monthly for your loan. For instance, say your monthly loan bill is $600. Instead of the monthly payment, pay $300 every alternate week instead. With the monthly payment method, you would pay off a total of $600 x 12 = $7200 annually. With the bi-weekly method, you would have paid $600 x 26 = $ 15,600 annually, an additional month of payments with just an extra bit of effort. Make this a ten-year loan, and you would have reduced your repayment lifespan by a full year, not to mention the interest paid.
Do stick to borrowing from a single lender. Otherwise, borrow from as few as possible.
Approaching only one lender for any kind of loan, such as your mortgage, tuition and credit cards will allow you to be charged lower interest rates. Sometimes, this also reduces the overall fee and even allows you to establish a good repute that helps in times of financial difficulty. Once you’ve established friendly relations with the lender, you’ll be able to enjoy the benefits in the long run.
Do keep your credit utilization rate at less than 30%
The credit utilization rate is the proportion of used credit measured against your total available credit. A rate or ratio that exceeds 30% will reduce your credit score and indicates that you are living on an excess of credit. This also indicates that you are likely in a financially strained situation. This ratio incorporates a significant part of your credit score calculation, hence maintaining a rate below 30% will reap the highest points.
The main takeaways of this article:
● The increase in aggregate household debt has reached close to $14 trillion in 2019 and shows no signs of stopping
● Being familiar with your credit utilization rate and debt-to-income ratio is essential to staying out of trouble
● Doing a comparison of the best rates, steering clear of variable interest loans and seeking help from only one lender are ways to borrow wisely
