Personal Finance debt, i.e. taking a loan, can be a great tool to build your wealth.
Loans can offer you many benefits, for example home and car loans help you achieve the financial goal of buying a home or a car (by making payments over a period of time) without having to wait and save enough to make an outright purchase.
However loans are often misconstrued as an instrument for the non-wealthy, when this is indeed not the case. Wealthy investors often use loans to help themselves get even wealthier. Where loans are concerned, you might find that you are one of two broad types of individuals. Each type has a unique viewpoint when it comes to taking a loan.
First, there are the emotional extremes - those individuals who either dislike loans so much that they will not borrow even a rupee, or those who like loans so much that they have over-leveraged themselves and might be now struggling under their EMI burden.
Second, there are the 'I'll Take It, But I Won't Like It' individuals. These are the ones that take a middle approach when dealing with their liability. Once they have taken the loan because they need it - the logical step, they then do their best to repay / prepay it as quickly as possible because of the mental or emotional discomfort caused by being 'in debt'. Most of us find ourselves in this second category.
The simple truth of the matter however, is a very factual truth.
A loan is simply the borrowing of funds, to be used for a particular purpose. Loans will simply give you the opportunity to incur the expenditure (for example, buy the house or the car) that you wish to incur, when you wish to incur it, and repay the amount a little at a time every month, over a specified tenure.
In this article, we will cover 2 aspects to personal finance debt.
- Different Kinds of Loans Available, and How to Ensure You Don't Over-Borrow
- Why it is sometimes Not better to prepay your loan
Different Kinds of Loans Available and How to Ensure You Don't Over-Borrow
An unsecured loan refers to any kind of loan that is not attached by a lien on any of your specific assets. This means that in case you default on the loan due to bankruptcy or any other reason, the unsecured debt lender does not have the right to claim any specific asset.
An example of this is credit card debt or perhaps a personal loan from a friend or relative.
A secured loan is one where you, the borrower, pledge some asset of yours as collateral to the loan. This means that in case of bankruptcy or any other reason for defaulting on the loan, the lender of your secured debt has the right to take possession of the asset (known as repossession) , and sell it to recover some of his loss.
An example of this is your car loan and home loan.
There are many options of loans and different lenders (from banks to housing finance companies to your relatives), which can help you take a loan when you need one. You need to ensure however that you don't over-borrow and put a strain on your finances. There is a simple way to check whether you are over-leveraged or not.
It is the Debt to Income Ratio.
Total monthly outgoings on liabilities (EMIs)
Debt to Income Ratio =
Total monthly income from fixed sources
As discussed, this ratio is simply the sum of your monthly outgoings (EMIs) on your liabilities, divided by your total fixed monthly income. It ideally should not be more than 0.35 (or 35%), else you may be putting a strain on your income to service your debt.
Before taking a loan, assess your monthly income and expense, see how much additional outflow you can afford to have on an EMI, and accordingly decide how much loan you can comfortably handle.
Remember, if you take a higher loan, you have to pay a higher EMI. The broad thumb rule is, your EMI will be as many thousands per month, as every 1 lakh loan you take.
So, if you take a loan of Rs. 20 lakhs, your EMI will be (approximately) Rs. 20,000 per month.
Why It Is Sometimes NOT Better To Prepay Your Loan
At PersonalFN we have come across many clients, who once they have taken a loan, prefer to prepay it as soon as possible because the idea of being 'in debt' is not comfortable for them.
This is a personal matter and while there is no question that these clients are genuinely feeling uncomfortable about the loan - it does not necessarily make financial sense to prepay as early as possible.
The reason is simply the opportunity cost of your money.
This means, if you have a loan which is charging you interest at 10% p.a., and you suddenly come into some surplus funds which you can either use to prepay all or part of your loan, or to invest, the first thing you need to do is check the opportunity cost of these surplus funds.
Would it make more sense to prepay the 10% interest loan, and thereby save yourself from paying the 10% interest? Or would it make more sense to invest the funds into an investment instrument that would earn you more than 10% - based on your risk appetite and time horizon?
For example, Mr. Shah (our favourite fictional character) has taken a home loan on which he is paying 10.50% interest currently. He has recently inherited Rs. 10 lakhs and wants to use it to partly prepay his loan. As there is no prepayment penalty any longer, he wants to prepay the loan up to Rs. 10 lakhs - the entire extent of the inheritance.
However, instead of prepaying the loan, if he invests the Rs. 10 lakh into a strong performing diversified equity mutual fund, then in the long term (3-5 years plus) he will likely earn a return of 15% per annum on this investment. So instead of saving 10.50%, he is earning 15%.
This is what we mean by opportunity cost. If he chooses to prepay the loan and save 10.50% interest, he is losing out on the potential earning of 15% return.
Remember, if there is an investment instrument which would give you a long term rate of return that is higher than the rate of interest you are paying on your loan, it would be financially more prudent to invest the funds and earn the higher rate of return, than to prepay the loan (in full or in part) and save yourself the lower rate of interest.
In addition, certain loans have tax benefits. For example, a home loan on a self occupied property helps you get a tax benefit of up to Rs. 1 lakh on principal repayment u/S 80C and interest repaid is deductible up to Rs. 1.50 lakhs. On a let out property, the interest deductible is not limited, you can claim full interest paid as a deduction from your annual taxable income.
So, remember - a loan can be a great tool to help build your wealth. Just remember to only take the amount of loan you are able to service without adding financial stress, and have a contingency fund set aside as well.