Taking out a loan is a commitment. You will get the funding that you need to get your first car or dream home. However, it will take a portion of your monthly income for months and years to come.
So, how do you know if you are ready to start shopping for auto or home loans? Here are the questions you first need to ask yourself.
Is the Purchase Absolutely Necessary?
Some people make the mistake of taking a loan to fund the lifestyle that they cannot afford. That is not how a loan works. You must only take out a loan when you find yourself in a position when you desperately need something but cannot pay for it out of pocket right now.
A car, for example. If taking public transport to get to work is not convenient for you at all, then a vehicle is a must.
Most of the time, there are products that seem important and you want in your life. You can put off buying it or not buy it at all. However, there are certain purchases that are absolutely necessary right now and you cannot wait months to years so you can save up money. That is when you should take out a loan.
Is There a Less Expensive Alternative?
People think they are getting into debt to make a purchase anyway, so why should they not get the newer and more expensive model? The truth is because you are borrowing a huge amount of money that you should scale back and look for the alternative that you can afford.
A car, for example, does not have to be new. There are tons of second-hand vehicles that are in mint condition and are priced far lower than the shiny new models you see in dealerships. If a second-hand car works the same way as the new one, why should you not choose it?
You can save money and make another big purchase. Moreover, you are assured that you can afford to pay the purchase off in the future.
Can You Pay Off the Loan?
This is the biggest factor that you should consider before you take out a loan of any kind. Likely, you will have to make major lifestyle changes and shift your expenses around so you can accommodate paying off your loan every month. Expect to cancel a vacation that you have been planning to go to or you may have to say “no” to going out with friends every weekend.
Calculate your debt to income ratio (better known as DTI). First, add up the total you spend on debt each month. That includes mortgage or rent, credit card payments, your student loans, or even alimony/child support payments. Next, determine how much is your monthly income from your work or business, bonuses, and overtime, or alimony/child support.
Once you have the exact numbers, you can do the math. Divide the monthly debt payment by the monthly income then multiply the result by 100. The percentage is your DTI. Your DTI should be the deciding factor if you should take out a loan or you should hold off the purchase. Ideally, your DTI is not higher than 25%.
A loan is a huge responsibility that, if you do not pay off, will have dire consequences. It will make your credit score look bad which, depending on the industry you are in, may affect your chances of getting a job. It will also be a source of anxiety and stress for you and your family.