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Rattan Chugh
ExpressMoney
Tuesday , April 24, 2007 at 1211 IST
Till about a generation ago, the average middle-class person bought a house with savings accumulated over half a working life, supplemented by provident fund withdrawals and soft loans from family and friends. Now, with rising incomes and easy access to all kinds of loans, even 20-somethings in their first job can think of buying a house. And a car, an expensive holiday, a foreign education…
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In an age of consumerism and instant gatification, easy access to credit lures us to chase our desires. It is empowering, but it also has its pitfalls. Many growing economies saw a significant number of individuals borrow and spend way beyond their means — and end up in a debt trap.
In an age of consumerism and instant gatification, easy access to credit lures us to chase our desires. It is empowering, but it also has its pitfalls. Many growing economies saw a significant number of individuals borrow and spend way beyond their means — and end up in a debt trap.
The incidence of defaults and debt traps could increase in India as more and more of us take credit to buy assets or spend. more so if interest rates rise and stay on the higher side. While it may be easy to get a loan today, remember that, every rupee you borrow must be repaid with interest, which can really add up over a long tenure. Whatever the kind of loan you take — home, car, education, personal or credit card — here are three questions to ponder over and answer before you sign on the dotted line. |
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| What’s the loan for? |
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The end use of the loan is a major factor in assessing the need for it. By one classification, end use can be categorised into two: productive and unproductive. Productive is when you use the money to acquire something, tangible or intangible, that boosts your net worth or earnings. For instance, a house is an appreciating asset; and if you move into the house, what you save by way of rent can be used to pay the EMI (equated monthly instalment). Another example of a productive loan is education loans. Not only does it enhance career opportunities, it is also likely to result in an increase in income, which can go towards repaying the loan. Such loans have a payback.
Then, there are loans that don’t have a payback, or are unproductive in nature. For example, borrowing to support an extravagant lifestyle at a scale that can jeopardise your financial future. Remember, the key to financial stability remains you live within your means — that is, don’t spend more than what you earn.
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| How much will it cost? |
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The next step is to figure out how much will you pay to take that loan. The interest cost is effectively what you will pay extra. Say, you buy a plasma TV worth Rs 1 lakh at a rate of interest of 20 per cent. If you repay the loan in four years, you pay Rs 43,671 as interest — 43 percent of the cost of the product.
Is that new gizmo worth that much? If you have the money, chances are, you are better off using it to buy that gizmo outright, instead of buying it on loan. Say, you have Rs 1 lakh invested in a bank deposit, which pays you 8 per cent interest, that too before tax. It’s simple maths that a better use of that 8 per cent bank deposit is to use it to repay your credit card dues on which you are paying a stiff 20-24 percent.
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The cost of borrowing |
The table shows the total interest outgo for
Every Rs 1 lakh of loan across various rates And tenures |
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| Rate of Interest |
| Tenure |
15% |
18% |
20% |
24% |
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| 2 years |
14,931 |
18,047 |
20,147 |
24,403 |
| 3 years |
23,255 |
28,225 |
31,596 |
38,469 |
| 4 years |
31,938 |
38,916 |
43,671 |
53,420 |
| 5 years |
40,977 |
50,109 |
56,357 |
69,223 |
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| How much can you afford? |
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f you don’t have such investments stashed away, you need to be sure you can service your loans without compromising on your current needs or, worse, slipping into a debt trap. For this, to start with, estimate how much you can pay back every month.
Add up all your expenses — rent, household spends, fuel, insurance premiums… A comparison of these expenses with your estimated salary will give you some indication of how much you can afford in monthly loan EMIs. Although we are living in a growing economy, it may not be prudent to over-borrow by banking on a big raise or a promotion.
Assuming that 50 per cent of your income goes towards expenses and in meeting other liabilities, and 25 per cent goes towards saving for long-term goals, then typically, not more than 25 per cent of your income should go towards servicing your loans. This number can be higher depending on your personal circumstances.
For example, if you have just started your career and live with your parents, you probably don’t have significant monthly expenses, which might justify a larger proportion of your income going to pay EMIs. Another instance of greater affordability is when both spouses are earning, and their collective income is examined to compute affordability. Similarly, if you have a home loan, perhaps, 30-35 per cent of your income can go towards EMIs, as you may save some amount on rent payment; besides a house is an appreciating asset.
So long as you borrow within your means and keep up with your EMIs, you can maintain financial stability and stay away from a debt trap.
The writer is CEO, Cornerstone Wealth Management
rattan.chugh@cstone.in
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