5 Principles of Sound Home Finance Literacy

Michelle Tuvey Michelle Tuvey | Loan Underwriter

If we learned anything from the financial crisis of the previous decade, it is the fact that a lot of people travel down the home finance road without really knowing where they are going. Fortunately, we have made a lot of progress in correcting the deficiencies of the past. But there is still work to be done.

Borrowing money without endangering one's finances is not something that should be left to chance. Indeed, borrowers should possess a certain level of financial literacy before they even think about borrowing. This is especially true when it comes to home finance. By its very nature, home finance puts a borrower's property in jeopardy if payment cannot be made. So borrowers really need to know what they are doing.

Here are five principles of sound home finance literacy every borrower looking for a mortgage or secured loan should be intimately familiar with:

1. Know Your Total Income

Knowing your total income is absolutely essential before you borrow on a secured loan or mortgage. You need to know every source of income, as well as how reliable those sources are. Each source will be considered in determining how much income you will have during the repayment period, so any income sources that are not reliable should not be counted on.

2. Know What You Can Realistically Afford

Partner to knowing your total income is knowing what you can realistically afford. This principle is where most people get into trouble. They look at their total income and their regular bills, then determine they can borrow up to the limit of the difference. Such a strategy is risky, at best.

A borrower's regular bills only constitute a portion of what will be spent every month. Other things always come up, though. A better way to estimate what you can realistically afford is to take the difference between your income and outlay and then reduce it by another 25-50%. The amount left over is what you can reasonably dedicate to monthly repayments.

3. Learn How Interest Rates Work

Interest on a mortgage or secured loan is represented on an annual basis. Borrowers are charged an annual rate based on the outstanding balance of the loan for that year. That means more interest is paid on the front of the loan than the back. This principle is critical to understanding how long-term borrowing works.

4. Understand the Role Credit History Plays

Credit history plays a vital role in home finance, and it determines the interest rate and terms a borrower will be offered. The better a person's credit history, the more favourable interest rates and terms will be. This suggests that people planning to borrow in the future should make every effort to maintain good credit between now and then.

5. Learn the Legal Ramifications of Default

Lastly, the legal ramifications of default in the home finance arena are extremely serious. They need to be taken seriously. Whether a borrower is applying for a first mortgage, a secured loan or a remortgage product, the property used as collateral against the loan can be seized by the lender if payment is not made. In theory, a borrower can faithfully make repayments for the first nine years of a 10-year loan and still have his or her house repossessed in year nine by defaulting.

Most of the home finance options on the market are great tools that responsible borrowers can use to meet their financing needs. But in order to borrow responsibly, borrowers have to have at least a basic level of financial literacy to guide their decisions.

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