Money Management
November 11, 2024
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Debt itself is not bad, as borrowing and utilising money well is one of the convenient ways of achieving your long-term financial goals. However, if you’re not careful, debt can be a destructive tool that ruins your finances. To prevent that from happening, you need to avoid unhealthy debt practices.
Unhealthy debt practices are those that put you at financial risk and make it difficult to repay your debt, and they manifest themselves in many ways. They can hinder your ability to achieve long-term financial goals, such as saving for retirement, buying a home, or starting a business, leading to financial instability and stress.
This article will explore ten common unhealthy debt practices and how you can avoid them to ensure the loans you take help you achieve your financial goals.
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If you're taking out a loan, you want to ensure you get the best deal possible from your lender. Borrowing money comes at a price, and the lower the total cost of your loan, the easier it will be to pay it off.
If you don't compare lenders when borrowing, you risk falling for unfavourable terms and higher interest rates from predatory lenders. Importantly, you might miss out on finding loan options that better align with your specific requirements, such as lower fees, flexible repayment options, or specific loan features important to you.
When comparing loans, you need to look beyond interest rates. You should consider the total costs of the loan, including application and processing fees. Next, ensure you read the terms and conditions, as this will help you understand the risks and potential charges you could incur.
To compare lenders, consider starting your journey online. For instance, you can use Money254's free loan comparison tools to find loans that match your needs. Then, you can proceed to get quotes from three or more lenders and compare their offers to find a suitable loan.
When taking out a loan, people often make the mistake of finding out how much they can qualify to get rather than how much they should borrow. This is not always the best strategy, as the amount you’d like to borrow isn’t necessarily the amount you’ll be able to get. What lenders will offer can be different depending on your eligibility and creditworthiness.
As such, knowing exactly how much you need to borrow is essential as it can help you avoid under-borrowing, which can prevent you from accomplishing your goal or over-borrowing, which can result in higher loan costs and debt burden.
Before applying for a loan, first, calculate how much you need. Next, determine how much you can afford to borrow based on your repayment ability and debt-to-income ratio (DTI). Finally, remember to be flexible, as your lender will decide how much you can qualify to borrow.
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Different types of loans are used for different purposes. Before you apply for a loan, you need to know what project or purchase the money will fund in advance to ensure you are applying for the right loan. And after you have been approved for the loan, you should use it for its intended purpose.
Deviating from the intended purpose may result in unforeseen consequences, making achieving your goals or meeting your financial obligations challenging. For instance, using your business loan to fund your kid's education might affect your business growth and repayment plan. Additionally, it can lead to legal consequences. Lenders can take legal action against you for breach of the loan agreement, potentially resulting in financial penalties or damage to your business credit history.
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Before you borrow money; you need to have a foolproof plan that ensures you won’t miss payments or default altogether. Failing to meet your debt obligation can have multiple effects on your finances. It can hurt your credit, lead to penalties that can significantly increase loan cost, loss of the collateral if they were any, and a lender might sue you to recover their money. A repayment plan will help you avoid all these effects.
Before applying for a loan, consider where you will get the money to repay it. If you plan to use the funds to cover personal expenses such as buying a car, will your income be enough to cover repayments? And if you are taking a business loan, will your business generate enough profit to repay the loan?
Some loans, such as personal or logbook loans, are paid back in fixed-rate monthly instalments, so you need to make sure you can afford to pay the loan back and meet your monthly living expenses. Finally, think about your long-term plans. Do you expect any other financial obligations to come up before you’ve repaid the loan in full?
When you borrow money, you will typically need to agree with the lender on the minimal debt repayment you will make over the loan’s tenure. It is typically the lowest monthly payment allowed to keep your account open and ensure you repay the loan in time.
You should always strive to make the lowest payments to avoid penalties/late fees and to protect your credit score. However, in some instances, you should consider paying more than the minimum. This will usually depend on your financial goals, e.g., wanting to get out of debt faster and the type of loan you’re servicing.
Paying more than the minimum can have multiple benefits, including saving you money as you will pay less in interest if you have reducing balance loan, preventing debt accumulation, lowering your DTI to help you qualify for other loans, and freeing up funds for other projects.
However, it is important to consider whether paying more than the minimum aligns with your financial goals. Spending a larger portion of your income on debt repayments can strain your budget, leading to cash flow issues and potentially hindering your ability to save money.
Repaying your loan early can help you alleviate your debt burden. This can help improve your DTI, free up cash flow, and eliminate the risk of variable rates loan increasing over time. However, it is not always the best option for everyone.
Depending on the type of loan and your credit agreement, early repayment can attract a prepayment that can drive up the total loan cost. Additionally, prioritising the repayment of low-interest debt instead of investing may cause you to miss opportunities to earn more money.
Before making an early loan repayment, consider contacting your lender and reading the terms of the loan to know the prepayment penalty.
Read Also: Paying Off Your Loans Early: Everything You Need to Know
Cosigning a loan can be a great way of helping a friend or family member access credit. However, it's not a decision you should make lightly, as it involves taking responsibility for someone's debt by guaranteeing the creditor you will assume liability if the original borrower defaults. You need to understand all the financial risks of attaching your name to someone's debt.
Cosigning a loan blindly can have multiple effects. The main one is that the lender will come after you and your assets if the borrower defaults. Second, it will affect your credit history. If you try to borrow before the original borrower repays their loan in full, you might be denied a loan, as lenders consider loans you've co-signed when profiling you. Finally, it might be impossible to remove yourself as a co-signer.
Before agreeing to cosign a loan, always do your due diligence to ensure the borrower has a solid plan to repay the loan. Additionally, ensure you have taken measures to help you recover the amount if they default and lenders come after you.
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Before taking a loan, it is crucial to understand the consequences of ignoring loan repayments or borrowing when you cannot afford them. If uncertain about your ability to make payments, consider avoiding loans and looking for other channels to raise money.
Missing even one payment can damage your credit score, making future loans costlier or unattainable. Defaulting on a loan may result in legal actions, such as lawsuits, salary garnishments, or property liens.
The inability to repay a mortgage or car loan can lead to repossession, causing financial losses and long-term credit damage. Continually assess your budget and ensure payments after borrowing to avoid delaying repayments.
Read Also: 10 Warning Signs You Are Not Ready to Take a Loan
Borrowing to pay off debt can be beneficial, but only when done for the right reasons, such as consolidating loans to make the debt more manageable, avoiding default, or reducing interest costs. However, this approach can be harmful if used to service loans that were initially unaffordable, leading to a dangerous practice known as loan stacking.
Loan stacking involves acquiring multiple loans from various lenders, typically digital ones, simultaneously to use the funds to settle existing debts. Unfortunately, this can lead to a vicious debt cycle and a dependency on loans, putting you in a precarious financial situation where you struggle to meet debt obligations and putting your credit ratings at risk.
This, in turn, may force you to keep borrowing in a desperate attempt to avoid being blacklisted by credit reference bureaus (CRB). Nevertheless, such a strategy is unsustainable in the long run unless you address the underlying debt problems.
Read Also: Why a Personal Loan is Ideal for Consolidating Debts in Kenya
Borrowed money should not be used to fund your lifestyle and pay for your living expenses.
Ideally, you should have a source of income and use earned money to pay your bills. Additionally, you should live below your means to ensure you are able to sustain your lifestyle without having to borrow. You need to know how much you make and often you get paid and create a budget that matches your financial situation.
To avoid putting yourself in a position where you have to borrow to fund your lifestyle in case you lose your income or have unexpected expenses, start building an emergency fund. Finally, instead of using loan money to buy consumer products, consider creating a sinking fund and slowly saving for big purchases.
Read Also: How to Pay Your Bills After Loss of Employment
The best way to avoid unhealthy debt practices is to be a responsible borrower. From the time you start searching for a lender to the point you make your last repayment and close your credit account, you need to ensure you make the right decisions that won't jeopardise your finances.
Shop around for interest rates, watch for any extra charges, and choose the right type of loan that meets your needs. Make your repayments on time to avoid penalties and prevent debt from piling up. Finally, Avoid unnecessary borrowing from multiple sources of credit to keep easy track of repayments. If you hit a roadblock, consider consulting your loan officer or a financial expert.
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