In a world with subzero interest rates, it is easier and cheaper than ever to take on excessive debt. With the U.S. consumer debt standing at ~ $15 trillion in 2021, the current data shows that this number will continue to trend upwards. As one of the most in debt age groups, millennials must be mindful before deciding to take on more debt. Excessive debt does not only affect your financial health. It could also have negative impact on your mental health and overall wellbeing. In worst case scenarios, even the borrower’s loved ones are affected. So, to avoid the stress cause by having excessive debt, there are key things you should consider before placing your signature on the loan document. Below we’ll discuss the key things to consider before taking on debt.
Is The Debt Worth It?
A concept that many people do not easily grasp is that when you borrow money today, you’re borrowing against your future. Therefore, before taking on additional consumer debt, you should perform a simple cost benefit analysis to determine if it is worth it. Some debts are long term commitments that must be adhered to regardless of changes to your financial situation after the initial agreement. Also, consider what are you gaining from taking this loan. A new business? A degree? A home? If the cost outweighs the benefits, it may be wise to reconsider taking on more debt.
Interest Rates (fixed vs variable)
There are two types of interest rates borrowers should be aware of: fixed rates and variable rates. Fixed interest rates do not change during the life of the loan (hence the name fixed). Therefore, if you take out a 4-year loan with an interest rate of 2%, your interest payment will remain 2% for all 4 years. The advantage of this type of rate is when interest rates increase, you’ve locked in a lower rate and thus pay less interest on your debt. However, the disadvantage is when rates decrease, you’re locked into a higher rate and will pay more interest on your debt.
Unlike fixed interest rates, variable rates can change multiple times over the life of the loan. Variable rates are usually tied to the Federal Funds Rate and changes in unison with this rate. However, to reduce the volatility in rate fluctuations, banks usually set an upper and lower rate limit. The type of rate on your debt matters because it determines the interest you’ll be paying on that debt. The advantage of variable rate loans is as interest rates lower, so will your interest payments and when they are higher, there is a maximum limit. However, the obvious con is you cannot take advantage of lower interest rates that fall below the lower limit and thus you’ll pay more interest on your debt.
Check Your Credit Score
Checking your credit score should be one of the first things you consider before taking on debt. It is common knowledge that those with a higher credit score usually receive lower interest rates on their debt. While those with a lower credit score usually receive higher interest rates on theirs. This is because your credit score helps lenders determine your credit worthiness. The higher score the more credit worthy you are perceived to be and the higher the probability that you’ll repay the lender. Ideally, to get the best rates, your credit score should be over 650. Click the link to learn more about credit scores [CLICK HERE].
Your personal bank is not the only place where you can get a loan. Different banks may be willing to offer you more favorable debt terms, therefore do not limit yourself to just one bank. Additionally, there are local credit unions that have historically offer their borrowers more favorable terms. There are also some credit unions who lend to non-members and those terms can be better than what your bank may be offering. Before taking the debt, apply to 2 or 3 other financial institutions for better terms or use that information to bargain for better terms at your home bank.
Make A Bigger Deposit
Making a bigger deposit is something you should consider before taking on more debt. What some people fail to understand it that the bigger your deposit, the less you pay in debt overall. This is because that deposit amount is not subjected to interest rates. Considering that interest rates determine the final amount that the borrower has to repay the lender, it is in your best interest to pay the most deposit amount that you can. Here’s an example of the amount that you can save buy double your deposit on an ordinary loan. See how you can save $110 just by increasing your deposit.
Know Your Debt-To-Income Ratio
Debt-to-income ratio is the percentage of your gross income that goes towards paying off debt. Knowing this number can help you determine if it is financially viable for you to assume more debt. This ratio is also used by lenders to determine your ability to repay your debt. The higher your debt-to-equity ratio the more of a credit risk you’re perceived to be. Ideally, you want your debt-to-income ratio to be ~36%. Unfortunately, many people ignore this important step when considering debt that they end up in financial distress or worse bankruptcy. In below example we see that for every $100 made $33 goes towards paying debts.
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