Is there such as thing as too much debt? One person may be comfortable with $5million worth of borrowings yet someone else may be struggling with the $5000 on their credit card. How do we work out how much is the right amount for us?
How loans work
There are two things you need when borrowing money, equity and serviceability. Equity refers to the value of the asset you are borrowing against. If you are buying a new car, the car is used as insurance against the loan. The same goes for a house or property. In the event that you can’t pay your loan, the lender has the right to sell your asset to recover the cost of the loan.
Serviceability is the amount of income you have that you can put towards paying off the loan. If you have no money coming in, it doesn’t matter how much your assets are worth, you won’t get a loan.
When borrowing, a bank may lend you up to 60% of your rural property or 80% of your residential property provided you have serviceability. But that doesn’t mean that you can afford your loans. Banks have a formula for determining how much money a person can reasonably live on. Any surplus is considered for repayments of the loan.
If you borrow right up to the amount that is offered, you could get into financial trouble if your standard of living requires more than the banks have allowed. Also, if interest rates rise or you change jobs, move house or have a medical situation, you may find it difficult to repay your loan.
Work out what’s right for you.
Each person is comfortable with different amounts of debt. If you are borrowing for something that will increase your income, factor this into the equation. If you are borrowing for something that will be used up quickly, factor in repayments so that you are not still paying for it when it is gone. If you are looking for a simple formula, a standard rule is not to have your total repayments exceed 25% of your income. This should give you a good buffer for those emergencies.