Taking a loan can give you access to the funds you need in a hassle-free manner. This is a great solution if you don’t want to borrow from friends and relatives. You can use a mortgage loan to buy a house, which allows you to use the house as collateral. Similarly, a car loan enables you to buy a car which you can’t afford. Business loans are a useful tool to help you achieve your business goals. You can even take a loan just to improve your credit rating.
However, you’ve probably come across numerous tales of people who were left in financial ruin after taking a loan. This is why you probably have misgivings about the aggressive advertising by banks when it comes to loans.
Now more than ever, banks are doing everything they can to attract new customers. One of the ways they are doing so is by marketing their loans. They will offer free credit reports, low teaser rates for loans, and no application fees. The approval for loans is also faster than ever – you can apply for a personal loan online and the money hits your account in a matter of seconds.
But just because your bank is willing to give you a loan doesn’t mean you should take one. Here are four golden rules to always have in mind before taking a loan:
1. Borrow only what you can afford to pay
“Live within your means” is one of the most common pieces of financial advice. The advice also applies to taking a loan. Ensure that you take full stock of your financial situation before requesting your bank for a loan. This helps you figure out exactly how much money to apply for and how much you can afford to pay in EMIs (Equated Monthly Instalments).
If you will be struggling to pay the EMIs, the loan will definitely stress you out. Financial experts recommend that EMIs for a car loan should not exceed 15 per cent of your net monthly income, for personal loans EMIs should not be more than 10 per cent of your income, while home loan EMIs shouldn’t exceed 40 per cent of your net income.
All together, the amount you are allocating to paying off loans each month shouldn’t be more than 50 per cent of your net income. If you are contributing more than that, your other financial goals – such as saving for retirement or children’s education - will be affected. Very often, people put retirement savings on the back burner to commit the funds to loans. This can be a very costly mistake in the long-term.
Base your calculations on what you’re currently earning, not on expected future income. If you relied on an expected income raise which doesn’t come through, you will be stuck with a loan you can’t afford. If you get an income boost in future, it is an added advantage which means you’ll have an easier time paying off the loan.
2. Keep the tenure as short as possible
The beauty of long-term loans is that they have lower EMIs, which might make them less stressful on the borrower. However, the longer term also means that you will end up paying more in interest. For example, if you take a loan at 9.75 per cent interest rate for a period of 10 years, the interest will be 57 per cent of the principal amount. This figure rises to 91 per cent is the tenure is for 15 years, and 128 per cent if you up the period to 20 years. And if the tenure is 25 years, you will end up paying 167 per cent in interest.
Although you can enjoy tax breaks on long-term loans, the cost will still be high. Therefore, unless the money you will earn from the loan is more than its effective cost, long term loans aren’t a good idea. However, there are cases where it might be necessary to take a long-term loan. For example, young adults at the beginning of their careers might not be able to afford the high EMIs for short-term loans. If this is your case, you can increase your EMIs when you get a promotion at work or find a more lucrative position.
3. Get insurance for big tickets
If you fail to pay the EMIs, the lender can repossess your house or car. If anything happens to you – such as illness – your dependants will also be saddled with the debt. This is why whenever you are taking a big loan, it is advisable to take insurance on it. A good loan insurance covers the EMIs not only in the event of death or disability, but also if you are experiencing financial difficulties.
According to financial experts, you should take an insurance cover equal to the loan amount. Insurance policies for loans are usually single premium plans. However, shop around for policies that allow for regular premiums as they tend to be more cost effective.
4. Pay EMIs in time
Discipline is paramount when it comes to repaying your loans. Whether you have a short-term loan (such as a credit card bill) or a long-term one (such as a home mortgage), make sure you make the required monthly payments in time. It is advisable to automate these payments from your account to ensure they are always paid even when you forget.
Skipping and delaying EMI payments can negatively affect your credit profile, which might make it harder to access other loans in future. Missing credit card payments can also leave you paying stiff penalties and a hefty interest on the unpaid amount. If for some reason you anticipate a delay in payments, inform the lender beforehand. For credit cards, always make sure you have enough to pay the minimum and roll over the balance.
5. Understand the terms
Many borrowers make the mistake of signing the dotted line without thoroughly reading the terms of the contract, including the fine print. Some lenders are known to slip clauses in the fine print that go against the borrower.
Although the prospect of reading through page after page of legalese isn’t appealing, you must force yourself to read and comprehend the terms. Alternatively, have a financial advisor or an accountant to take a look at the agreement before signing.
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