Tips on Making Debt Work For You
Types of Debt
Not all debt is bad. Debt that tends to boost personal wealth and even cash flow may be considered good debt.
When a person stretches himself beyond his means, overspends and is unable to settle his loan repayments, the debt is considered bad debt. He lands himself in a debt trap when late payment charges pile up, causing the debt to grow even bigger.
Debt to pay for further studies that will boost your future earning prospects, could be considered good debt.
Loan Considerations
Any money borrowed that has to be paid back from future income and anything that could affect that future income will affect your ability to pay back that loan.
Before you take on any new debt, you should consider the following points.
1. What is the purpose of the debt?
Ask yourself if the loan is for consumption or investment purposes. If you plan to indulge in an expensive car, the loan might become an unsustainable bad debt. But if you want to pay for further studies that will boost your future earning prospects, it could be considered good debt.
2. Can you really afford it?
Carefully consider your other monthly payment commitments, both fixed and variable, before taking on new debt.
Look at how much you will have to pay in total after you add the proposed new loan installments to your existing commitments, then ask yourself if you are still comfortably within your disposable income level.
You must also examine how you are going to pay back the loan - assess just how secure your future income is.
3. How are you going to repay the loan?
If the loan is to be serviced by both spouses, then you must weigh the consequences should one spouse lose his or her job, or decide to stay at home to look after the children.
4. How high is the interest rate?
If the interest rate is 24 per cent a year, the standard rate for unpaid balances on credit cards, then forget it - this is not an option.
5. Do you understand the terms and conditions of the loan?
Some customers are not aware that when promotional interest rates are offered - say, 3.99 per cent a year - to customers who roll over their credit card balances, the offer is good for a specific period only. Once the promo is over, the rate reverts to the higher 24 per cent rate, the standard rate imposed on outstanding card debt.
6. How steady is your income?
If you earn a commission-based salary, your future income stream might be unsteady, so you have to be more careful when assessing your ability to service the loan.
7. What portion of your income goes to your debt?
Debt repayments should not exceed 25 per cent of your income; otherwise servicing the debt might become painful.
If the loan is being serviced by both spouses and one becomes jobless, the other will have to take over the balance of the loan, so the debt to income ratio will double.
8. What happens if you cannot pay?
Getting out of a credit debt trap
Most experts advise clearing debts with the highest interest first. Then settle debts with variable interest rates.
At the top of most lists would be credit card bills, which if left unpaid could easily double within a few months and lead to spiraling levels of debt. However, if you are in danger of defaulting on, your home loan, keeping up your repayments for that might be more important than clearing debts with higher interest rates.
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