Understanding the basics of borrowing

Like it or not DEBT is a four letter word. We all borrow but some of us do it better than others. Before deciding to apply for any form of credit you really should stop and ask yourself the following questions. The answers to these will help you distinguish between essential debt and debt which is likely to become troublesome and costly.

What is the loan purpose?

Why do you wish to borrow? Is it in order to gain access to some goods or services that you can not afford to pay for in full now? How essential are these goods or services to you? Are they simply something that you want to have now, or are they part of your long term financial plan.

For example, if you are borrowing to cover the cost of your education which will eventually allow you to qualify for a better paying job and earn more money in order to repay this education debt – the loan has a valid purpose.

On the other hand if you are borrowing money to go on a holiday or pay for a wedding, this is what is seen as a lifestyle debt which will accumulate in cost over time without being able to add to your long term financial well being. I am a strong believer in avoiding lifestyle debt whenever possible. If you have been unable to accumulate enough money to go on a holiday through working and saving then you can not afford such a holiday. How will you be able to afford to pay off the holiday debt together with the interest cost levied on that debt ?

Can I comfortably afford the repayments if something goes wrong?

Even where the debt has a reasonable purpose like a car or a home, do not rely on your lender to assess your loan affordability. Your lender may not know that you are planning to have a baby or change careers. Make sure you can comfortably afford to repay the debt taken even if something goes wrong, or at worst you have an exit strategy.

What is my exit strategy?

You cant always predict the future, however you can take the time to think what you will do in the event you lose your job, get sick, or some other unforeseen event occurs. Some borrowers take out loan insurance to protect themselves from such an eventuality. The main thing is to decide what your exit strategy may be if you can not afford the loan taken. Some people may decide to sell the asset and repay the debt. However in the case of a car loan quite often the car is worth less at a point of time in the future than the monies owed on it. This is where planning to borrow just enough but not too much is important. Just because you can afford the repayments on a $60,000 car loan is not necessarily a good reason to take one.

With unaffordable mortgages an exit strategy may be to move out and rent the property out for a while or perhaps sell up and buy something cheaper.

Am I getting the best deal?

Have you done comparisons on the form of finance you are looking to commit to and similar products offered by other lenders.  Just because the CBA is where you have your savings account and their branch is right next to your place of work, does not mean that they are necessarily the best place for you to take out a car loan or a home loan. They may well be of-course – but it pays to compare and check.

What is the opportunity cost of this form of finance ?

Have you considered the opportunity cost of your new credit card? Probably not, but in signing up for that shiny peace of plastic you may have reduced your home loan affordability by as much as $100,000 or more. It does not matter that you owe nothing on the card. The mere fact that you can go out tomorrow and spend up big, will limit your potential home loan by a lot more than the credit card limit.

Similarly if you sign up for a holiday club or a time share – while the amount itself may not be huge, the fact of that debt being present on your credit report will restrict the amount that you will qualify for when it comes to car finance or a mortgage.

Remember no loan stands alone. Any debt you take on will limit your borrowing capacity going forward – so choose wisely.