Go back a couple of years in time and talk to people who borrowed money to buy a house or a car. Chances are that they will recount the paperwork, filling of forms and the time they had to wait for the approval to come through. Cut the chase to today—rarely do you need to fill application forms. Everything happens instantly, you tap on your phone or log on to a website and enter information, wait briefly in some cases for an approval to come through. “I used my credit card to apply for a loan to by the new iPhone in 2015. It all happened so fast thatI started using the phone within hours,” recounts 32-year-old Neha Rajput.
The proliferation of the digital works has resulted in the mushrooming of several portals thatfacilitate loans almost instantly. And then there are several other services that come with a pre-approved loan. “Combined with external credit information, we are in a position to make very informed credit decisions about the customers looking for personal loans,” says Rajiv Anand, Executive Director (Retail Banking), Axis Bank. The interest rates, which is the cost on which the loan is available, have stopped being the major factor that drove people to borrow. The convenience of life on EMIs has made it easy for an entire generation to get instant gratification.
Our outlook to borrowed funds has changed drastically. Consumerism, cheap credit, flexible repayment and loans not being a taboo subject anymore, has encouraged people to borrow for practically everything. “This year, I bought a saree costing about Rs.20,000 on EMI,” states Rajput. We all have taken so well to the new climate of life on credit that we have stopped asking whether we are borrowing too much. We all agree that debt is no four-letter word and there are number of situations when borrowed funds make perfect sense. It is, in fact, a great personal strategy to achieve some financial goals.
Borrowing right
“Taking loan for an appreciating asset makes sense, like home and education. For buying a home, you can take a loan of up to 3-4 times of your annual income,” says Neeraj Chauhan, founder, The Financial Mall. Manisha Singh would agree.
This 34-year-old Bangalorean used a loan to fund an executive development programme from IIM Indore. She also bought an iPhone through an EMI on her credit card. “Borrowing was an easy choice to realise my dreams. Instead of just dreaming, I have actually realised them,” she says.
It’s not just about availability. When it comes to home loans, the tax breaks are so attractive it makes sense to take a loan that effectively you may be paying 1-2 per cent lower than whatever the borrowing rates are. However, the loan that is being predominantly taken is a personal loan or converting credit card spends on to EMIs. The interest rates on such loans are significantly higher and do not provide any form of tax benefits. The variation in lending rates when it comes to such loans is also not very transparent.
For instance, it was a 3 per cent variation in rates that rattled 35-yearold Kapil Adlakha. “I had taken a personal loan to refurbish my house because of the less laborious paperwork,” he says. He was wise in moving his personal loan from Citibank to HDFC Bank last month. Another mistake that many tend to make is take a cash loan on a credit card, or worse—revolve the credit card balance by paying the minimum balance or less than the full balance. So, even Rs.20,000 in emergencies at a little below three per cent interest rate every month would balloon to Rs.50,000 if not paid in time within a couple of months.
Today, you can get a car loan within minutes of a test drive and drive home in it. Credit helps you achieve tangible aspirations and lets you build assets much earlier in life. It is also one of the tenets of financial planning: build assets early in your life. However, most people tend to not channelise EMIs into asset creation—they tend to choose a lot more of lifestyle-related products that depreciate in value.
Check out the consumer durables market, or just go to any e-commerce website and you’ll see that goods now come with an EMI tag rather than a price tag. There is a significant shift in attitude, which comes from easy availability of credit and the availability of products that call for raising debt. “I would advise you to hold your impulses and wait patiently till you accumulate funds to buy consumer durable and gadgets. Buying these on loans or credit card EMIs would mean forgoing substantial discounts on cash purchase,” advises Chenthil R. Iyer, chief strategist & trainer, Horus Financial Consultants. Such an approach ends up being a double whammy—you buy at a higher price and also have to pay interest.
Deft handling of debt
The availability of credit helped Adlakha tide over the urgency to get his house in order, but it also propelled him into paying more than he should have. Obviously, for him, there was no choice but to take a personal loan at a steep interest rate was not a good move. The lesson for everyone is to stay off taking credit just because it’s there for the asking. The question before buying anything on credit, especially products that depreciate in value, is not if you really need it, but do you understand the real cost of the purchase.
The simple rule of borrowing—borrow only if you can earn more than the rate at which you borrow it for. Some really smart borrowers use this tactic to their advantage. For instance, it is common for some investors to maintain an overdraft with their bank against their stock portfolio. They use this borrowed money to reinvest in the stock markets, where they earn a higher return. They are the smart ones who exploit debt than be exploited by it.
A way to smartly negotiate debt is to understand how much you can actually borrow to safely repay without any defaults. “Lenders usually would like applicant’s EMI commitments to be up to 50 per cent of the monthly income when sanctioning a loan,” says Shaji Varghese, General Manager and Business Head, PNB Housing Finance. What this indicates is that one should borrow in a manner that the money that goes into servicing their loans is not more than 50 per cent of what they earn. The assumption being that the balance 50 per cent is adequate to meet the household expenditure.
You must clearly understand what you are using the debt for and how it will work for you. Typically debt comes under two guises—debt you incur to fund an expense, which can be called consumption debt or debt that you use to fund an asset, like say a house. When you take on debts like home or education loans, you create an asset early and, while still enjoying it, you are able to repay it well in time. The value of the house goes up and its future earnings by way of rent most often only appreciate in value.
Likewise, when you take an education loan, you hedge your future earning potential. The complexion of education loan changes the moment you take it to fund your child’s education, as it becomes a consumption loan. In the same vein, when you buy a car on an EMI, it is easy of course, but this loan is a pure expense loan. The problem arises when many people forget to understand that owning a car may not be difficult; but it could be difficult to manage its maintenance and running costs, which are not factored in when borrowing to buy the car.
Optimising debt
The cheap credit atmosphere you live in means you have to exercise that much more restraint. Like managing your investment portfolio, you have to now learn to manage debt. This could include balancing one loan against another to make the most of what’s available. Although Rajput, Singh and Adlakha have not got into a debt trap or a situation that can put them in a tight spot, it may just take a few instances that could put them in a situation which increases their financial challenges.
A way to navigate debt smartly is to understand the concept of debt-tonet income ratio and how much it works well within limits. “For buying a home, you can take a loan of up to 3-4 times of your annual income,” suggests Chauhan. While taking a car or any other kind of loan, the EMI should not exceed 20-25 per cent of net salary. “Your comfort level will be high if total EMI is below 40 per cent of your take home salary,” says Chauhan. Anything outside this range and you are on your way into a debt trap. There is also a range when it comes to servicing education loans—the EMI should not exceed 20-25 per cent of the net pay. In the case of multiple loans, your EMIs should not exceed 40-45 per cent of net income.
While an EMI is tempting and looks very much affordable, you need to remember that your monthly budget and cash flow position change when you are servicing debt. The difference between net income (inflow) and expenditure (outflow) will give you your cash reserve figure, based on which you can decide the amount of loan you can safely take.
Today there are loans for vacations, homes, credit cards, car loan, personal expenses and to get married and more, but that is no excuse to go gaga. To handle credit smartly, set a limit. A careful person will take a loan, service it comfortably and then go on to his next goal. Who knows having borrowed to fund her education and an iPhone, Singh may soon land up taking a loan to buy a house and build an asset for life.
