Getting into debt to fund your lifestyle is not a sensible move. The general rule of thumb is to avoid personal debt for trivial reasons. Like a watch, you’ve seen? Save until you can afford it. Want a vacation? Start putting money aside instead of going to a bank for a loan you’ll have to pay back.
But there are often very good reasons to take out a loan. Loans can be of many sorts – and can be used to finance anything from new automobiles to your own home. But while debt equity can be very helpful for emergency funds, or for securing a long-term asset, it’s important to be careful and not get into debt you can’t afford. Here are Xpress Money’s top tips to quickly calculate the amount of reasonable debt you can afford.
Check legal limits
Sometimes, Central Bank regulations impose upper limits on the debt a bank can offer to a client. For instance, the UAE Central Bank caps personal loans at 20 times the monthly gross salary and limits the repayment period to 48 months1. The Central Bank also stipulates that the Debt Burden Ratio, or the amount of money required to service all debt over a month, mustn’t exceed 50% of total monthly earnings.
So, for instance, someone earning AED 10,000 a month can only avail themselves of a total AED 200,000 loan in the UAE, with a maximum of AED 5,000 going into serving all debt every month. In the UK, unsecured personal loans are usually capped at GBP 25,0002.
Loan limits depend on many things – your country of residence, type of loan, and duration. The first step is to check your local regulations to determine how much you can borrow.
Is there room in the budget?
A regulatory check is only the first step. Just because you can legally borrow up to a certain limit doesn’t mean it’s a good idea.
A good rule of thumb is to check whether there is money left over at the end of each month in your budget to service loan instalments. If there’s no space in your budget to pay further instalments, servicing your loan might require you to take on further debt, which quickly results in a vicious circle.
The general rule of thumb for prudent financial management is that car loan instalments shouldn’t exceed 15% of your monthly income, while servicing a personal loan should only require 10% of your salary each month3. Any more might see you start running into budgeting difficulties.
How secure is your job?
Quantitative checks on whether you can service your loan only go so far. Taking out a loan should also involve qualitative risk assessments – starting with job security. How safe is your job? Might you be made redundant or be forced to take a pay cut? Generally speaking, taking on debt in an uncertain job market is not a good idea. Either cut back on the sum you plan to borrow or defer applying for a loan until times are better.
Asset or expenditure?
There are many categories of loans, but they can roughly be filed in two main filing cabinets – loans to purchase an asset, and personal loans to bridge a shortfall in finances or meet a sudden expenditure. As a rule of thumb, loans to purchase assets stretch longer term and can be for higher sums. These loans are more secure for both consumers and banks – because the money is being funnelled into an asset. In a worst-case scenario, defaulting on an asset loan will mean foreclosures, but at least a debt settlement will be made available. Personal loans are riskier because there’s no underlying asset that can be sold or offered to the bank in lieu if you can’t meet your obligations.
Fees and charges
It’s a common mistake to only consider the principal when calculating the loan you can afford. But loan agreements can be complicated. Check for variable interest rates – which are often built into mortgage agreements. Also investigate hidden fees, charges and penalties for late payment – because these can quickly add up. Ensure that you take into account every possible outlay, and add them to the loan total before deciding whether you can afford it or not.
Loans are a very powerful tool that can empower you when buying a car, purchasing your home, or financing future plans. Bank debt greases the wheels of commerce. Access to credit is a lifeline for consumers and businesses alike. But caution needs to be taken: there’s a fine line between useful debt and being hopelessly in debt. With Xpress Money’s quick tips, we hope you’ll make your loan decisions with a bit more thought and care.