Yes… Rich people do that.
Why not, they do it smartly.
A DEBT is known simply as a sum of money that is owed, to be paid back at a specific time. Debt can be acquired in a lot of ways but for the sake of this article, I will be focusing on loans. There are a lot of reasons why people apply to get loans, which could be received from family and friends or financial lending institutions.
However, these are things you already know… let’s talk more about the things you might not know and no one is in a rush to tell you.
There’s a popular misconception about debt: that it’s outright bad… This, I have found to be untrue. Still, since debts have a significant impact on the financial aspects of our lives (either positive and negative), we should think more carefully before we lend money. This is where being able to differentiate between “Good debts” and “Bad debts” comes in.
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Why Loan money?
For whatever reasons there might be, loaning money boils down to satisfying specific expenses. It could be to buy a car, pay school fees, purchase a home, even gadgets, or anything that requires immediate cash outflow. This is often done with the help of a lender (mostly banks).
If you know how different types of loans work and the particular features they offer, you will be better equipped to look for one that’s best suited for you if the need ever arose.
In some ways, all loans are similar to each other. Money is borrowed (principal) and agreed to be repaid over a term or at a specific date with interest. The most important details of these loans contain pitfalls for inexperienced eyes.
- Type of loan
- Interest rate
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Type of Loan
These can either be installment loans or lines of credit.
Installment loans are the more popular and traditional loan system. When taken, you borrow the money all at once and repay it in set amounts or installments, periodically. Installment loans are closed-ended loans because they must be paid in full by a specific date.
While a line of credit is a type of rotating credit, similar in many ways to a credit card. It lets you write special checks for the amount you want to borrow, up to a limit set by the lender.
The credit doesn’t cost you anything until you access the line. Then you begin to pay interest on the amount you borrowed. You must repay at least a minimum amount each month plus interest, but you can repay more, or even the whole loan amount, whenever you want. Whatever you repay becomes available for you to borrow again. Banks and credit card issuers sometimes offer lines of credit automatically to people they consider good customers. But that doesn’t mean you have to borrow if you prefer not to.
- Only one application
- Instant access to credit
- Potentially high-interest rate
- Easy to borrow more than you can easily repay
According to interest rates, loans can be classified into fixed and adjustable rates.
Many installment loans have a fixed rate. The interest rate and the monthly payments stay the same for the term of the loan.
- Installments stay the same
- Easy to budget payments
- The cost of the loan won’t increase
- No surprises
- Interest remains the same, even if market rates decrease
- Initial rate higher than adjustable-rate
- Not always available
- Could cost more
An adjustable-rate loan has a variable interest rate. When the rate changes, usually every six months or once a year, the monthly payment also changes.
- Initial rate lower than fixed-rate
- Lower overall costs if rates drop
- Annual increases usually controlled
- Can be easier to qualify for
- Vulnerable to rate hikes
- Hard to budget for increases
CHOOSING A TERM / DURATION
The term of a loan is critical to the cost of borrowing. Assuming the same principal and interest rate, you always save money with a shorter term because you pay less interest, though the monthly payments are larger. What’s more, some shorter-term mortgage loans offer lower rates than longer-term loans with the same principal, reducing your cost even more. But if you’re concerned about being able to afford the larger payments on a shorter-term loan, paying somewhat more interest with a longer loan may be wiser than risking the possibility of default.
Here’s an example that illustrates the effect of term on three $15,000 car loans of different lengths.
Number of monthly payments
Amount of each payment
Total interest paid
Good debt is a debt that comes with favorable outcomes. Examples of these include:
● Education loans
People who are unable to afford the amount needed to finance their education are sometimes forced to apply for scholarships or the usual alternative which is education loans. An education loan is good debt because it leaves the lender more qualified for higher-paying jobs when it’s time to start repaying the lender.
A rule of thumb for getting an education loan is to make sure the total amount of the loan receives does not exceed your total yearly earnings after graduation.
Hypothetically, If the new job pays you 200,000 yearly, the amount received to finance the education must be lower than this amount.
That way, if you were to pay 3% of the loan collected monthly plus interest, it would only take a few years to get even.
After total repayment, the 3% is added to your monthly liquidity (money at hand) and it can be used for whatever purpose you deem fit.
● Financing a Startup or Existing business
This form of loan financing is considered a good debt because of the probability of success in such a venture. Although, it is considered wise to start with smaller loans when funding startups or existing businesses.
However, funding a business on the verge of bankruptcy with a loan is not considered a good use of debt acquired in my opinion. This is because there are too many uncertainties and little to no margin for error.
● Home or Real Estate mortgage
This is a loan taken to finance the acquisition of landed property either to increase your assets and ensure income or merely for personal usage. Just by looking at this from any angle, it’s a win for the lender, considering you hold up your end of the bargain. Failure to do so leads to forfeiture.
Bad debt is a debt that ends in a more problematic situation than the initial. Bad debts can be broadly classified under the term Consumer debts.
Consumer debts are of no short or long-term value. In short, the value of consumer debt starts to depreciate immediately after first use.
Examples of consumer debts include;
● Gadget and Automobile loans
Some gadgets and automobiles are available to be purchased in installments from approved stores all over the world, but not until recently in Nigeria. Although, I consider this to be unnecessary unless it is of dire need. I believe there are other affordable and cost-friendly options available.
A much-preferred example would be setting up short-term savings whereby you get paid interest on the money you saved.
Piggyvest is one of the few platforms that tailor various saving options to your needs.
Benefits of Piggyvest savings plan include:
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As opposed to living in debt and being at the mercy of various unexpected expenses crippling your loan repayment plan.
Other consumer debts come in form of credit card debts and so on.
There is however one scenario where consumables, especially automobiles, can be worth financing with a loan. This scenario would be if you were to purchase antiques like the 1996 Mustang… Now, that’s a treasure
But, this article would not be complete if I fail don’t note that good debts can become bad debts, bad debts can become good debt. The secret to making good debts of all money loaned is to mitigate all risks and ensure it is tailored into the constraints of your capability.
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