Needing to borrow money? Four tips on what’s okay and what’s not

It’s a financially challenging time for most households. With interest rates rising, many are spending even more money on debt repayments or taking out loans to help make ends meet.

A report released recently in South Africa, compiled by one of the country’s biggest banks, found that 42% of South Africans, across various income levels, cannot manage their debt. This indebtedness has caused 67% of the respondents to worry about their debt to the point that it negatively affects their mental health.

As a new year gets underway, it’s a good time to reflect on your financial portfolio.

My research as a finance and financial planning academic seeks to understand the pathways that lead to economic empowerment and improve financial security, including the role of debt and other financial products.

There may be instances where the use of a credit card might be absolutely necessary (for example if you are making travel bookings). But for the most part, if you are borrowing to pay regular expenses, increasing your credit limit, or using a credit card (or borrowing money from family) to pay off existing debt, then it may be worthwhile to consider these four tips on borrowing money.

Four tips

Firstly, it’s good to know what amount of debt is okay to hold.

There is no easy answer to this because everyone’s financial situation is unique – and this will determine how much debt each person should draw on. Making this assessment requires knowing your ability to service debt. In other words, the amount of debt you take on should be guided by your ability to comfortably repay it.

The debt service ratio is a useful tool to determine this. It’s calculated by dividing your monthly debt by your monthly income. Say for example your monthly debt repayment is R6,000 and you earn a monthly salary of R30,000. You’d have a debt service ratio of 20%. As a general rule of thumb, a debt service ratio of 25% or less is considered acceptable.

Calculating this ratio will help you set a limit for how much income you are prepared to commit to your debt repayments.

Secondly, be picky about who you borrow money from.

Financial institutions, such as banks or other formal money lenders, are the most popular sources for borrowing because the terms of borrowing, fees and interest rates can be determined in advance. More than that, borrowing from a regulated and recognised financial institution helps build a credit score, and, as counter-intuitive as it may seem, you need debt to take out debt. If you need to take out a more substantial loan in future, such as a mortgage or vehicle financing, then having a loan from a regulated financial institution helps to determine your credit score. Your payment history, account information, amounts owed and how long the account has been active are on record. This can give a good indication of your ability to service a future debt commitment.

Thirdly, there are sources of borrowing you should avoid.

There are many ways and places to borrow money from – but not all of them are advisable.

It is common (and sometimes culturally accepted) to borrow from friends or family. But almost everyone who has gone down the route of borrowing from loved ones knows that it has the potential to ruin relationships when the terms of the repayment have not been honoured. Friends and family may not charge interest and tend to be more flexible than formal financial institutions. But borrowing from those close to you can cause a significant strain on a relationship – and even end it.

Then there are the loan sharks who charge exorbitant interest rates on their loans and get away with it because they are unregistered and unregulated. They also prey on the vulnerability of consumers who need a loan and resort to unscrupulous tactics when the loans aren’t repaid on time. Being in debt is stressful enough and borrowing from an informal moneylender can only do more harm than good.

Fourthly, be scrupulous about what you’re borrowing money for.

Debt can be used to buy almost anything, from a cup of coffee to big ticket items such as a car or a house. However, anything that does not have a significant monetary value or is consumption-driven – clothing accounts, entertainment, or appliances – should not be financed through debt. That’s because the interest or fees of the credit used to buy consumable goods is often greater than the value of the consumable itself.

When you buy anything through debt, it’s worthwhile to ask yourself whether the purchase is worth the interest that is attached to it, and the future income you will need to commit to repaying the debt.

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Knowing how much debt you should have, where to acquire it and what to use it for can make a huge difference to your financial well-being. Even though it has its uses, debt can quickly become a slippery slope when it’s not properly and consistently managed. If you are unsure about how to use debt, it’s always better to seek the help of a professional financial adviser.

Bomikazi Zeka, Assistant Professor in Finance and Financial Planning, University of Canberra

This article is republished from The Conversation under a Creative Commons license. Read the original article.