4 Questions to Answer before you Borrow
Are debts bad? This is a question that has created conflicting responses and answers. Sadly, I don’t have any answer for you either.
This question arises because nobody wants to do things that are considered ‘bad’. I always say debt is debt; it is not essentially good or bad.There are countless benefits to living without debts especially the flexibility that comes with not having a chunk of your income dedicated to some fixed payments. Again, with debt payment lurking all around you, you might never be able to reach your financial goals.
However, if you must go for any form of borrowing, it is smart to consider these FOUR bigger-picture relevant questions that speaks to your entire wealth before signing on the proverbial dotted line.
HOW MUCH TOTAL DEBT CAN I AFFORD?
It is important to keep the ‘big picture’ in mind when making any borrowing decision because the total amount of your debt can affect a host of several aspects of your financial and personal life. It is healthy to go for the debt if your monthly inflow can cover more than twice your monthly payment.
Most financiers would want to consider the percentage of your overallincome that will be devoted to debt payments (Debt-to-Income Ratio). It is used to measure your ability to successfully liquidate your debt with your current income. A low debt-to-income ratio demonstrates a good balance between debt and income while a high debt-to-income ratio signals that you may have too much debt for the income you make.
Illustration: If you earn$5,000 in a month at your job. If on a monthly basis you pay $1,200 for mortgage, $400 for car, and $400 for the rest of your debts. Your monthly debt payments is:
$1,200 + $400 + $400 = $2,000
With amonthly gross income of $5,000, debt-to-income ratio would be 40% ($2,000 / $5,000 = 0.4). Debt can be covered twice and over.
But if your gross income was lower at $3,000, your debt-to-income ratio would be 67% ($2,000 / $3,000 = 0.67). This is high and shows that you can only comfortably cover your debt once.
WILL THE LOAN PAYMENTS LAST LONGER THAN WHAT I’M SPENDING IT/THEM ON?
The next criterion for determining if taking on a debt is advised is to know if in the loan term is less than the life of the asset you are applying the loan towards.
A 25-year mortgage usually makes sense for a home purchase because the asset life of the house matches (or exceeds) the loan term and is an asset that will appreciate in value.
A student loan for education can be considered same if and only if the college or graduate school education results in a career that can provide a ‘higher’ lifetime income stream and increase one’s net worth.
This may not be said for car loan. Cars depreciate rapidly and are not always kept for long.
Illustration: Jayden takes out a five-year loan for $25,000 to buy a new Saloon Car and pays 5% interest. When he drives the car off the lot, it will lose about 10% of its value, and by the end of the first year it will have depreciated by a total of about $5,000 (20%). After one year of making payments, Linda will still owe $21,000 on the Saloon Car, but it will be worth only $20,000.
WILL THIS DEBT INCREASE MY NET WORTH?
The basic barometer of your wealth is ‘Net Worth’ which is the difference between your assets and your liabilities. In several ways, your net worth represents the sum total of all the financial decisions you have consciously or unconsciously ever made in your life to date.
In financial planning, a major goal is to increase net worth over time, either by increasing income/assets, decreasing debts/other liabilities, or both. Some debt can help to increase your net worth which should still be subjected to our question analysis.
Illustration: You buy a house for $500,000, putting down 10% ($50,000) and financing the rest with a $450,000 mortgage at 4%. Monthly mortgage payments will be $2,148.37. Note that your net worth has still not changed at all.
Originally, you had $50,000 in cash. You have a debt of $450,000and your house is now worth $500,000 (still the same net worth of $50,000). The finance cost and other home acquisition expenses will increase this amount which makes it a bad idea to go ahead with the borrowing.
However, note that some debts can be beneficial by financing investments that increase your net worth.
DO I REALLY NEED TO BORROW THIS MONEY NOW?
This is the last but best of the four questions;it is also the easiest one to avoid asking ourselves. Most times the answer is obvious.
Large debts are racked up with small separateexpenses/purchases. Check if what you want to get is instant gratification from the borrowing. When taking funds from family and friends, do you need to borrow this money or you have an opportunity starring at you in the face to exploit?
Plan to make your purchases with cash instead of using credit cards or simply wait for 24 hours before buying what you think you needed –it often results in a decision not to buy after all.
Don’t think that a little debt won’t hurt. That was how it all started for most people I know.
The Bottom Line
Debt is a financial tool that, like many things in life, can be both harmful and helpful. Don’t just seek to know the basic terms when you are making that plan to borrow but also consider the questions above.
Debt can be extremely crushing at times. It is best to avoid needless debt financing, and to be both informed and smart in our use of debt when we do borrow.
Go for the debt-free life!
