Posted by Allison on 4 April 2009, 10:23
The global credit crunch has illustrated better than anything else could that it's never a good idea to borrow up to your limit – let alone beyond it.
In recent years there has been an unfortunate trend among banks, building societies and credit card companies to offer people far more credit than they can handle. Bigger mortgages, bigger credit limits on your cards and huge loans being offered to you through the post have all become a part of everyday life – and unfortunately a lot of people have made the mistake of giving into temptation and applying for all the credit they can get.
There seems to be something of an assumption among some people that if you are offered a large amount of money, then you must obviously be able to handle that amount of debt. Unfortunately if these same people actually sat down and did their sums they would soon realise that this is very far from being the truth.
In years gone by a 100% mortgage (a mortgage which is for the full purchase price of the property) was unthinkable and not recommended. It was far better to save for the deposit and get a smaller mortgage instead – even if it took you several years to do so.
But in recent years when the prices of housing went so high that it was virtually impossible to get on the housing ladder at all, banks started to offer 100% mortgages as a matter of course, which may now turn out to be a foolhardy thing to have done.
This has certainly proved to be the case in America, where people are already struggling to get to grips with the huge amount of debt in their currency that they have found themselves saddled with. If ever we needed a lesson in what happens when you overextend yourself, we only need to look across the water to get it.
The problem with applying for the largest mortgage you can get is that you are leaving yourself with no room for manoeuvre. Those interest rates only need to creep up by the tiniest amount and you could find yourself unable to pay your monthly payment. If that happens you could find yourself in real trouble.
But overextending yourself like this has another downside as well. There is also a much higher chance that you will find yourself with negative equity. If you borrow 100% of the purchase price and the value of your house goes down, you will instantly be stuck with negative equity. If you have managed to put down 10% of the purchase price however, you will effectively own 10% of that property and the price will need to drop by more than that 10% to leave you in the same position.
This illustrates the need to have a cushion between what you owe and what you are effectively able to pay for. If there is no cushion then you can expect to get into trouble very quickly if the interest rates rise or house prices go down.
So why are so many people tempted to get into debt for amounts that they can hardly ever hope to pay back?
The answer is in that sentence – it's pure temptation. If someone offers you something you are more likely to take it than if you looked into the possibility by yourself. As soon as someone says, “Yes, we can give you a 100% mortgage” you know that it is a real possibility, regardless of how easily you will be able to find the money to pay for it.
That's why it's advisable to give yourself a cooling off period whenever you are seriously considering taking on any more debt or loans of any kind. Ask yourself whether you really need it in the first place. Take a good look at your finances and see how easy or hard it would be to make those payments each and every month. And consider also the emotional side of things.
Just as people are quite often ruled by emotion when they are thinking of taking on that tempting loan, they are also ruled by emotion when it comes to paying for it. Have you ever been in the situation of having to count every penny (or cent or rouble or whatever other currency applies in the situation) every month and worrying about whether or not you will be able to manage in the months ahead?
If you have you will be a lot less likely to take on too much debt in the future, because you will know first hand how stressful it can be. It saps your energy and really makes it difficult to concentrate on bringing the money in and spending it wisely in the first place.
As it stands thousands and thousands of people are already starting the face the consequences of overextending themselves when credit was on offer so readily. The question is how this will affect the world at large. We have already seen a major bank in the US run into dreadful problems, as well as a major financial outlet in the UK. If banks and building societies can run into major financial problems because of the credit crunch, it would be foolhardy to assume that individuals could not get into the same mess.
But unfortunately it is too late to avert this particular financial disaster. Once you are overextended like this there is no quick solution to extracting yourself from the situation. While some people in the US have simply walked out of the house they can no longer afford to pay for and not looked back, they are only a symptom of a much larger problem.
Until society as a whole can understand the idea behind credit and learn to handle it responsibly – no matter how much or little currency they may borrow – things are unlikely to change very much at all. It looks like the coming months may be a big lesson for everyone.