Avoiding the Financial Pitfalls of Debt: How to Make Bank Loans Work to Your Advantage

It was Thomas Jefferson who famously said, “Never spend your money before you have it.” This, however, is easier said than done. If the average person waits and saves before buying a house, they may have to wait until their retirement age to purchase that dream home for their family.

The reality is, unless you are left with a hefty trust fund, you’ll eventually need to borrow from a lending institution or bank to finance your education, home, car, business, or other needs. While most people view debt as inherently bad and should be avoided at all cost, there is such a thing as a good debt.

A good debt is a kind of debt that adds value to your life and increases your net worth. Some examples of a good debt include student loans, business loans and mortgage because these loans, in a way, are investments because it will have a return in the long run. Nonetheless, some loans are only good for certain types of borrowers such as loans for investment, loan consolidation, and credit card reward programs.

There’s no need to be afraid of bank loans. As long as you have a financial plan in place and you avoid the common pitfalls that would result in a debt trap, you’ll be on your way to financial freedom in no time. What are these common pitfalls? Read on and find out.

1. Buying a New Car

Everybody knows the value of a new car depreciates as soon as it leaves the showroom. Sure, you get to enjoy the scent of a car that’s fresh from the factory for a while, but think about how much its value decreases over a short period of time. At least 20% of your car’s value will be lost on the first year alone, and about 49% after its 4th year on the road. In comparison, a 1-year-old used car will have an average depreciation of 17.5% per year, saving you a lot of money in return.

2. Investing and Loaning Without an Emergency Fund

Before getting your first loan or investment, you have to build your emergency fund first. As a rule, this fund should be equal to at least 3 to 6 months of your salary. This is an essential part of your financial portfolio because it’s a buffer against life’s curve balls.

Medical emergencies, sudden unemployment, and natural calamities are just some of these unexpected moments you have to be ready for. Having an emergency fund to lean on can mean the difference between keeping your house and dealing with a foreclosure.

3. Paying Only the Minimum Amount of Your Credit Card

When you receive your monthly credit card statement, as much as possible, try to avoid paying the minimum amount due and pay the total amount due instead. Paying the minimum amount due will surely let you accumulate credit card debt that will be hard to recover from.

The ideal use of credit card should be for convenience and accumulation of reward points rather than become the root cause of more problems. Use it for paying your utilities, insurance, and other needs to gain reward points, but always pay the full monthly due to avoid the added 3% to 10% charge, as well as the carried over balance for the next month.

4. Getting the Lowest Monthly Amortization for a Housing Loan

Before you decide on the kind of housing loan you should get, the interest rate is a critical factor that you should never forget to consider. Is it a fixed or variable rate? How long will you be paying the monthly amortization? How much is the difference in interest rate?

Here’s something you should remember: the shorter the loan, the higher the monthly amortization and the lower the interest rate.

For a housing loan, a fixed rate is recommended if you have a shorter loan term of about 5 years. This fixed interest rate protects you from the fluctuations in the market, though you may miss those dips in interest rate, at least you have a consistent monthly payment and won’t have to worry about unexpected highs.

Of course, if you can’t afford the high monthly amortization, you are free to go for the longer 10 to 20-year term but it comes with a larger interest rate.

Being financially literate is the best defense against debt traps. Only when you are armed with the right information can you make the best decisions that will surely benefit you. So read what you can about the loans you are interested in, and whatever you do, don’t skip the fine print.

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