Loans can seem like a quick fix, offering a way to get what you want now, whether it’s a new home, a car, or funding for education. But that “now” comes with a “later”—the responsibility of paying it all back, with interest! A common mistake people make is thinking they can easily handle the repayments, only to find themselves struggling later on.
Factors That Lead to Overestimation of Repayment Capabilities
Before we discuss the hows, we need to understand the whys.
One of the biggest reasons people overestimate their repayment ability is emotional and impulsive spending. Sometimes, we want something so badly that all logic goes out the window. We make buying decisions based on what we feel, not thinking about its long-term impact on our finances.
Sometimes, we also make decisions based on what our friends or neighbors are doing, leading to unnecessary debt. The need to keep up with others is very real, especially in our world today where Instagram posts tend to “dictate” the kind of lifestyle we should all aspire to.
Another issue is being too optimistic about our income. Relying on bonuses or side hustles that aren’t guaranteed can lead to trouble if those extra funds don’t materialize. And it’s easy to underestimate everyday expenses like groceries, utilities, and transportation.
Without a clear picture of where your money goes, it’s hard to know how much you can realistically afford to pay back.
How Do You Avoid This Pitfall?
The first step is to create a detailed budget. Start by listing all your fixed expenses, like rent or mortgage, and then track your variable expenses for a few months. Use a notebook, spreadsheet, or budgeting app to see where your money is going. This will help you distinguish between “needs” and “wants.”
Many free budgeting apps are available, and some are particularly popular in Singapore. Remember, the goal is to get a realistic view of your spending.
Next, be conservative when projecting your income. Base your repayment calculations on your stable, guaranteed income, such as your salary. Don’t rely on bonuses or other uncertain sources. It’s also wise to build an emergency fund to cover unexpected expenses or income gaps. This will provide a safety net if things don’t go as planned.
Another crucial strategy is to “stress test” your finances. Imagine worst-case scenarios, like losing your job or facing unexpected medical bills. Calculate your repayment capacity with a reduced income to see if you can still manage. Also, consider the impact of potential interest rate changes, especially if you have a variable-rate loan from a Singapore licensed money lender or bank. In Singapore, it’s important to understand the potential effects of inflation on your expenses.
Utilize online loan repayment calculators and tools. These can help you estimate your monthly repayments and understand the total interest you’ll pay. Look at the amortization schedule to see how much of each payment goes toward the principal and how much goes toward interest.
If you’re unsure about anything, seek advice from reputable financial sources. In Singapore, some agencies offer financial counseling. Outside of Singapore, look for certified financial advisors.
Finally, pay attention to your debt-to-income ratio. This is the percentage of your monthly income that goes toward paying debts. A healthy ratio is essential for financial stability. Calculate your current ratio and set realistic limits on how much you borrow.
In Singapore, you’ll hear about the Total Debt Servicing Ratio (TDSR), which is a specific rule for property loans. But the general concept of keeping your debt load manageable applies everywhere.
Wrapping It Up
Responsible borrowing is about being honest with yourself about your financial situation. It’s about planning for the future and being prepared for unexpected events.
By creating a realistic budget, projecting your income conservatively, and stress-testing your finances, you can avoid overestimating your ability to repay loans. Remember, financial stability is crucial for your overall well-being. If you’re ever in doubt, don’t hesitate to seek professional financial advice.
