Understanding debt – reasons why you might borrow, things to consider before committing to a loan

Before taking on any debt, you should ask yourself whether you really understand the topic of debt, loans and credit. You should consider:

  • Whether you are borrowing for the right reasons
  • Whether you can afford to repay the loan
  • Whether you have chosen the most appropriate form of borrowing

Reasons for borrowing

A recent ‘financial literacy’ survey of more than 18,000 customers of short-term lender Wonga South Africa showed that 83.7% of people would borrow to fund a house purchase, and that 58.6% would borrow to pay for the costs associated with going to university. 5% said they might borrow to pay for a holiday and 4.5% would consider loans to purchase gadgets, technology or fashion.

The first two are examples of what might be said to be ‘good’ debt, as the loan is taken out to fund some form of investment, on which you might expect a financial return. You might expect the value of your home to increase, and that you could earn more throughout your career as a result of having a university degree.

The last two are most certainly examples of ‘bad’ debt.

Repaying your debt

You should never take out a loan or other form of credit unless you are confident that you will be able to meet your repayment obligations. As a general rule, financial experts recommend that you don’t spend more than 35% of your net salary on debt repayments. However, everyone’s circumstances are different, and the cost of living can vary dramatically between different areas, so don’t use the 35% figure as a hard and fast rule. Instead, you should consider using a budget planner to work out exactly how much you are spending in various areas, and consequently how much you might have left to make debt repayments.

Additionally, don’t just focus on the amount you will need to repay each month. Consider also the total amount you would need to repay to clear the debt. If you repay your debt over a longer term, then you may be shocked as to exactly how much you would need to pay back in total.

Different forms of borrowing

There are many different ways you can borrow money – credit cards, overdrafts, personal loans, micro loans, secured loans etc. Before entering into a new debt commitment, consider which of these methods is most appropriate.

Some lenders use the ‘3Cs’ when deciding whether to lend money – capacity, character and collateral.

Capacity refers to whether you have the means repay the debt. A lender might want to know your occupation, how long you’ve worked there, and how much you earn. They will also ask about your expenses: how much do you spend each month on food, clothing, travel, utilities, communications and other areas.

Character is concerned with whether you are likely to repay the debt. Here lenders examine your credit history: how much you have borrowed in the past, and how often, and whether you have been able to maintain repayments on your previous credit commitments.

Collateral refers to the fact that lenders will ask for some form of security for some types of loan.

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