Debt can be a great way to finance a purchase or improve your financial situation, but it’s important to consider all of the consequences before taking on debt.
There are a few things you need to consider, including the amount of debt you’re able to handle, the interest rate you’re paying, and the potential for late fees and penalties.
It’s also important to keep in mind that debt can have negative consequences, such as limiting your freedom and increasing your risk of becoming homeless.
What to Consider Before Taking on Debt
There are many things you may want to consider before taking on any debt. Although debt when used wisely, can help you to build wealth and secure your finance.
Debt is a double-edged sword, when a person is over-leverage and taking on too much debt, it can have negative consequences, such as limiting your freedom and increasing your risk of disaster, such as defaulting on loans and becoming bankrupt or even homeless.
Here are a few things you may want to consider before getting into debt.
1. Know your credit scores
Credit scores are one of the most important factors in obtaining a loan or a personal credit rating. Your credit score is a numerical indication of your creditworthiness. It’s based on your total debt, including both consumer and mortgage loans, as well as other debts such as student loans and car loans.
Before you apply for a loan, you should know your credit score.
Most credit score falls between 350 to 850 and most lenders (banks and financial institute) will check for your credit score before determining your defaulting risk.
- A credit score of 300 to 549 is considered bad with the highest defaulting risk.
- A credit score of 550 to 619 is considered poor with a high defaulting risk.
- A credit score of 620 to 678 is considered fair with a medium defaulting risk.
- A credit score of 680 to 739 is considered good with low defaulting risk.
- A credit score of 740 to 850 is considered excellent with the lowest defaulting risk.
The average credit score of a person living in the United State is 698, and this number varies widely between different states.
How do credit scores affect you?
People with a high credit score will have the benefit of getting a loan at a lower interest rate, while people with a low credit score will usually mean a higher interest rate with lesser banks willing to approve their loan.
Factors that affect credit score
- Payment history
- Amount you owned
- Length of credit history
- Availability of balance in the bank
- Number of open accounts
- Number of loans
2. Understand the APR
The annual percentage rate (APR) is the percentage of the unpaid balance of a loan that is charged as interest each year. It is expressed as a yearly rate and includes all interest and fees charged over the life of the loan.
Not all rates are equal
APR can differ widely, depending on the type of loan you get and how you borrow it. For example, personal loans from a bank tend to have higher interest rates than those obtained from a credit union.
The lower the interest rate, the less expensive it is to borrow money. Thus a lower interest rate is better, as it will save the individual money in the long term. This is because a lower interest rate means that you will pay less money in interest over the life of the loan. Which can help an individual pay off their debt faster.
If you are considering getting a loan for your house, to study, or even for investment, it is always worthwhile to shop around for cheaper rates. As a high-interest rate can add thousands of dollars to the cost of a loan.
A loan with a lower interest rate of even just 1 percent can result in hundreds of dollars in savings per year.
3. Prepare your documents
In order to get a loan, the borrower must complete an application and provide documentation that shows that they meet the eligibility requirements. The list of documents required is usually listed on the website of the bank or the financial institution.
Commonly required documents for getting a loan
- Proof of income, such as past 12 months’ payslip
- Proof of residency, such as a bank statement
- Proof of employment, such as notice of employment
- Proof of your identity, such as a photocopy of your ID
Most loan providers will also check for your past 60 days’ bank balance before giving you a loan.
Once the documents are verified, the lender will approve or deny the loan based on the credit score of the borrower and other underwriting criteria.
4. Understand the terms of the loan agreement
Before you sign anything, make sure you understand the terms of the loan agreement.
The average person signs a loan agreement without reading it. This can be a mistake because loan agreements have clauses that can be quite confusing. Loan agreements usually have terms and conditions that the borrower must agree to in order to receive a loan.
Some of the most common terms are interest rates, repayment schedules, loan terms, and loan forbearances.
- The “Interest Rate” Clause: This clause sets the interest rate on the loan.
- The “Amortization Schedule” Clause: This clause sets how often the loan will be paid off.
- The “Loan Term” Clause: This clause defines the length of time the loan will be outstanding.
It is important to understand these terms so that you can make an informed decision about whether or not to sign the agreement.
You may also want to speak with a lawyer or financial advisor to help you understand the finer points of the agreement.
5. Know how are you going to repay the debt or loan
Debt and loans can be very beneficial tools for people, but it is important to know how you are going to repay the debt or loan before borrowing.
- Are you going to pay off your debt with your monthly salary?
- Are you going to pay off your debt through the earnings from your business?
There are a number of ways that you can repay the debt, depending on your situation, you may want to repay your loan differently.
Often, you may find it helpful to speak with a financial advisor to find the best way to pay off your debt.
How to pay off debt effectively?
There are a few key things to remember when trying to pay off debt effectively. One is to make a budget and stick to it. This will help you figure out how much money you have available to put towards your debt each month.
There are 2 common methods that people use to help repay their debt.
- Debt Snowball Method
- Debt Avalanche Method
The Debt Snowball Method is a technique for debt management that involves paying off debts in order of smallest to largest, regardless of interest rate. This method has the advantage of motivating you to pay off your debt.
The Debt Avalanche Method is a strategy that focuses on paying off the debt with the highest interest rate first. This method makes the most financial sense but can be demotivating as debt repayment is a long process.
Both debt repayment methods have their advantages and disadvantages, it is up to you on deciding which methods suit you the best.
Things to remember when taking up debt or loans
There are several things to remember when taking out debt or a loan.
- Think about your budget and whether you can afford to pay back the loan.
- Research different lenders and compare interest rates.
- Make sure you understand the terms of the loan agreement before signing anything.
- Be realistic about how long it will take you to pay off the loan.
- If you decide to get a loan, make a plan to pay it off as quickly as possible.
Questions to ask before taking up debt
- What return do you expect to get and what if you don’t?
- How are you going to pay the debt, and can you afford it?
- How do you expect life to look after taking on this debt, what if things don’t go as planned?
These are just some questions to guide you before you decide to take up the debt.
Because all debt has to be paid someday.
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