Ideally, a person should spend only up to the amount that he/she earns. However, in the absence of an emergency fund and insurance cover, one may have to borrow during an unforeseen contingency. One may also borrow to increase the earning capacity and to purchase long-term assets.
However, while borrowing, you should keep in mind that loans create the obligation to repay the debt from future earnings.
So, indiscriminate borrowings or making mistakes while borrowing may leave you bankrupt in case you fail to repay your loans.
Mistakes in Borrowing
You should avoid the following mistakes while borrowing:
Higher borrowing than your capacity
As borrowings create obligation to repay the principal amount along with interest, you should borrow only that much, which you may repay without much difficulty. You should also keep in mind that you have to repay the loan amount from your future earnings and any disruption in the earnings may jeopardise the repayment. So, borrowings higher than your comfortable repayment capacity may create the risk of getting bankrupt.
Borrowing money for expenditures
You should borrow only when the cost of borrowing is less the benefit that it generates. For example, taking student loan for a professional course that provides good placement, fetching much higher benefits even after repaying the loan. Or taking home loan to buy a house that would not only appreciate in value, but also help you save the house rent.
However, if you borrow for expenditures like for buying luxury items, getting married, travel etc, you will have no long-term benefits, but your future earnings will be used in repaying the debt, thus limiting your future spending capacity. Any disruption in future earnings would make you bankrupt, as the loans can’t be repaid by selling the underlying assets, like that of a home loan.
Borrowing money to buy things that depreciate in values
Buying depreciating things like latest gadgets, luxury items etc – that don’t provide direct benefits in your business or profession – will limit your future spending capacity by creating obligation of repaying the loans. As such assets don’t help in increasing future earning, the burden of EMI may create a situation, when you may not have spare money even for buying essential items.
Not prioritising which debt to pay first
If you have a number of loans, you may have to prioritise the repayment in case of money constrains or having extra money for pre-payment. You need to repay the costly loans first. If you fail to prioritise, the burden of interest payment would mound over time.
To be guarantor in a loan
By becoming a guarantor, you may end up wearing the shoes of a borrower even without taking a loan and enjoying the benefits of it. In case of default, you have to repay the loan. In case you don’t have the capacity to repay, you may face bankruptcy.