Tips for Making Economical Use of Loans and Managing Debt
There are a few simple disciplines for managing borrowing so it does not get out of control and to make it serve the borrower rather than the lender.
To control debt and borrowing it is more important to consider the term of loans rather than seek to minimise monthly repayments.
Match Loan Periods to the Life of the Benefit
Most people need to borrow for major purchases. Houses and cars are the highest value items that most buy but few can pay cash. That means borrowing. The key is to borrow over a term less than the life of the benefit. So for a house 25 or 30 years is reasonable as a home should last at least that long, but for a car five years (or less, especially if it is not new) would be more appropriate. Other items, say a PC, might be even less.
That way the borrower does not end up still owing money when the car, computer or whatever needs to be replaced.
Many people pay for their annual holiday by borrowing, which is not ideal as it is an everyday expenditure. But if it is necessary to borrow for the annual vacation then the loan should be repaid within 12 months otherwise it will still be in the process of being repaid during the following year’s holiday and will reduce the pleasure.
Do Not Borrow for Everyday Expenditures
Using loans for normal living expenses and everyday replacements, like clothes, is a bad idea. Funding an income and lifestyle mismatch with credit causes debts to grow. They become difficult to service when interest rates or other costs rise. This is happening now with the credit crunch and expensive borrowing combined with rises in fuel and food prices.
Borrowing for a night out or a party is complete nonsense. Any loan will long outlast the fun. There may be a double hangover – one immediate from the party and then long-term debt. It applies to all normal expenditure like clothes, food, utility bills or household maintenance and repairs - pay for it out of income.
Treat Your Savings Account as a Loan Company
Everyone should have savings and should seek to grow them steadily. A good approach when using such savings is to treat the withdrawal as a loan from the savings account to the purchaser. Savings should then be repaid over an appropriate period exactly as if it were loan and with interest comparable to commercial loan rates. That way the opportunity cost of the purchase is eliminated and good discipline is maintained, and savings grow.
Student and Career Loans
Career development loans should only really be taken out if the return in increased earning power will allow the borrower to repay the loan in reasonable time after completing the course. However, it is recognised that some education is for purpose other than better income but repayment should still last less time than the benefit.
If study does lead to increased income then the extra cash should be used to repay the loan before making lifestyle improvements. Assuming the student lived relatively economically during study then it is easier to continue a frugal lifestyle than trying to economise from a more expensive lifestyle when the graduate's expectations and peer pressure will get in the way. By paying the loan down quickly it also minimises the interest paid and reduces the time in debt.
Start Out With a Disciplined Approach to Debt
These suggestions are recommended to everybody but especially young people moving into life independent of parental support. Adopting these disciplines reduces the likelihood of debts growing because money is still owed on previous items when a further loan is required for their replacement.
Further advice on personal finance can be found on Suite101 - worth reading with this article are Control Your Debt, which provides a warning to reinforce the message as is Dangers of Credit Cards.
First appeared on Suite101