Thursday, September 16, 2010

The Principles of Borrowing

From AKPK

What are the Basic Principles of Borrowing?

Having understood the components of a loan, we’re now ready to learn about some of the basic principles of borrowing.

Principle 1: Borrow for something that you need – not want.

We have talked about the difference between a Need and a Want before and when it comes to borrowing, it’s even more important that we understand this difference. You should only borrow for something that you really need but don’t have the cash to pay for it. For example, to purchase of our home, to send our children for further education and to a lesser extent, to buy a car (we’ll talk about this later).

Principle 2: Borrow an amount that is within your repayment capacity

This may sound like common sense but unfortunately, it isn’t common practice. A lot of people over-commit themselves into debt thinking that the economy will continuously expand & the good times are here to stay. Needless to say, when crunch comes, these people will be struggling to keep up with their repayments & repossessions of cars and foreclosures of properties begin to mushroom. A case in point will be the current subprime loan crisis in the US.

It is advocated that one should keep one’s total loan repayments to less than 1/3 of one’s gross income.

Principle 3: Avoid borrowing to finance depreciating assets

This might ruffle some feathers but it’s nevertheless a good principle to abide to. Depreciating assets are things that lose its value over time, like a car (unless you’re “investing” in a classic car), furniture and most of the household items & gizmos. It doesn’t take an economics professor to tell you that borrowing at a relatively high cost (maybe as high as 20% p.a. for some items!) to purchase these “assets” just doesn’t make good economic sense. These items would depreciate very quickly in value whilst your loans reduce rather slowly. In the event of default, the items would be repossessed and you are obligated to top-up the shortfall as your depreciated assets are not sufficient to cover the outstanding loans.

Try to purchase these items with cash through your savings rather than borrowing. Otherwise, don’t buy (unless it makes good business sense)!

Principle 4: Avoid Being a Guarantor

A guarantor steps into the shoes of a borrower in the event, for whatever reason, of a default. Unless one is prepared to honour this commitment, one should avoid being a guarantor.

Principle 5: The Borrower has a Moral and Absolute Commitment to Repay

Have you met any persons in your life whom have borrowed from you but have yet to repay? How do you feel? Frustrated? Cheated? Betrayed? Yes, it’s certainly not a very good feeling and you should never give any excuses for not repaying your debts once you’ve made a promise.
If you have a problem repaying, talk to the lender to work out a feasible repayment plan but never keep quiet or run away. Otherwise, don’t borrow!

Conclusion

If you need to borrow, by all means, borrow! However, be sure that you clearly understand the principles before committing into it. Once you borrow, you are literally making a commitment to repay and kindly ensure that you, as a responsible individual fulfil that commitment at all times.