Loans: Is it Good, Bad or Ugly ??

When I was very young my grandfather was planning to buy a house, as loans were not easy to get so the State Govt had come out with a scheme in which a person can buy the home and pay in instalments for next 15-20 years and the final ownership of the house is transferred after making full payment. However my grandfather decided to buy the house with full payment as taking a loan was something he call as “Shaan Ke Khilaf” i.e. bad for the Self Reputation.

Yes that was time when taking a loan by a middle class person was considered as “Daag” a blot in self-respect.

Time has changed a lot since then and now most of the people in 30s may have one or two loans. Yes we are in consumerism. We want to enjoy everything today whether we have money or not, does not matter as we can get loan for everything right from home to cars to electronic gadgets, for holiday’s and even weddings & other petty things also.

So few questions comes to our mind especially among young earners who find it tough to fit their expenses into their incomes:

1. Is it good to be debt free?

If we can control our expenses and don’t get carried away with other’s life style it is possible to live completely debt-free. However it is not necessarily a very smart way of living life. There are certain assets which requires a lot of money to buy like House, Car and college education, and very few people earn enough money to pay full cash for them on upfront basis. So in today’s world it may not be very smart decision to be totally debt free while denying ourselves some basics which can be paid back comfortably later on.

2. Should we borrow as we are getting it easily?

Now the next question comes should we borrow as someone is offering it. Now days most of use to get dozens of calls for personal loans, credit card etc. Does it mean that should we take it just because someone is offering it and use to buy the things which may not be otherwise bought? Nothings comes free and we should always remember it. If we have taken the loan we need to pay back along with the interest.

3. So what is Good Loan?

Good loan is something which is used to buy an asset that will grow in value or generate long-term income. Let’s understand it more.

A home loan to purchase a home for living is usually considered good loan. Home loans generally have lower interest rates than other loans, plus that interest is tax deductible.

Education loans to pay for a college education is another example of good loan. First of all, education loans typically have lower interest rate compared to other types of loans. Secondly the interest paid on education loan is fully deductible from the income and thirdly, a college education increases your value as an employee and raises your potential future income.

An auto loan is another example of good debt, particularly if the vehicle is essential to doing business. Unlike homes, cars and trucks lose value over time, so it's in the buyer's best interest to pay as much as possible up front so as not to spend too much on high-interest monthly payments.

4. What is Bad Loans?

Bad loan is a loan incurred to purchase things that quickly lose their value and do not generate long-term income. Bad loan carries a high interest rate, like credit card debt and there will be no tax benefits as such. The general rule to avoid bad debt is: If you can't afford it and you don't need it, don't buy it.

Loan for expense which can be avoided like wedding, electronic gadgets and fancy items whose value erodes quickly are considered as bad loans and should be avoided.

Taking Loan for a new start up can turn out to be a bad idea. Starting our own business can often be a life changing experience. However, we should avoid taking a personal loan for the investment. This is because there are plenty of better options such as roping in co-investors or angel investors, or choosing asset-based loans, small business loans, etc.

And the UGLY

Taking loan for Investing in stock market is risky, although there are people who may have made a fortune from their investments. However, if you want to invest in stock market by taking a personal loan be careful as it can easily end badly. Companies go bankrupt all the time, and if your money is on one then you could end up paying EMIs for a loan that dissolved completely. It can be further worse if you take a loan for derivative trading as then the liabiliites goes beyond the loan amount due to leverage trading.

Credit card is worse for undisciplined spenders. As we do not hesitate to swipe a card, since the brain is unable to process the pain of parting with money, while we focus on the joys of spending. Outstanding amounts are charged usurious interest rates since the unpaid balance is an unsecured loan to the cardholder. The minimum amount due seems small and convenient, but instantly converts the unpaid balance into a high cost loan.

5. So, why we should not overburden ourselves with loans?

Indebtedness is not just a financial burden but also emotional burden.  It can create resentment in our life and may affect our family and office work. People who carry huge debts face anxiety and depression. People start living in denial and lie through their debts, creating a façade of well-being while avoiding the calls from creditors, or stashing unopened mails about overdue debt away from sight. Indebtedness makes us less capable of being a better version of ourselves. It also affects our self-respect and we try to avoid people or places from where we have taken loans. It is always better to take loan which we can comfortably reply.

6. So, what is the thumb rule while taking Loan?

1. First thing we should know that will this loan have a direct and measurable positive impact on future income? If the answer is yes, we may go for it. Like Crop loan when sowing is good or an education loan for a course in a reputed institute could be a good idea.

2. Is the loan small enough for me to pay without impacting my other regular expenses? Rather than looking how much finance company give me we must look at our own cash flow position to ascertain that how much EMI I can afford to. There is an old saying “ Pair utne hi failana chahiye jitni lambi chadar ho” We should spread our legs only as much as the length of the sheet.

3. Is the loan creating an obligation whose value is too risky given the size of your assets? For example in derivative trades the obligation goes beyond the purchase amount and can put a huge obligation for the investor and hence doing derivative trading by taking loan can be a very dangerous idea.

Few Final Words

Loan is a commitment to pay from our future income for the things which we want to have right now. Yes we may take some of the things in advance by loan but we should be careful to manage them in case the future income does not comes as per our expectations. We should also remember that our loan EMI’s should not result into the curtailment of the current necessary expenses.

Warrant Buffet has once said: “If we buy the things we actually don’t need then in future we would be selling the things which we actually need.”