LOANS – GOOD DEBT OR BAD
DEBT?
·
Debt is not
always a negative thing.
·
Managed well, it
helps you to leverage your future income to build assets and wealth for
reaching your financial goals.
A. WHY IS DEBT NEEDED?
·
The demand for
loans comes from two primary household needs:
o
Asset builders
for building assets
o
Liquidity seekers
against locked non-liquid assets
·
There are two
principles to keep in mind while using a loan:
o
It should either
fund an appreciating asset
o
It should be
repaid from a steady future stream of income.
·
A loan is a
funding source to enable asset-building by a borrower.
·
A loan also helps
in unlocking the value of an asset against which it is taken, thus enhancing
the borrower’s ability to repay.
·
While funding an
asset, your own money should be at least equal to the possible erosion in the
asset’s value.
·
Always consider
the loan’s interest rate, processing fee, service tax, prepayment penalty, etc.
to assess the actual loan repayment.
·
Keep the bank’s
base rate in mind while negotiating for the loan, and ensure the interest rate
remains same throughout the tenure.
·
For higher loan
amounts, you can bargain for a lower interest rate if you provide a higher
security equivalent, guarantor or collateral.
1. What is a good debt loan?
·
A loan can be termed
as a good debt if
o
It creates a
valuable asset for more wealth in the long run.
o
It enhances your
personal skills for creating wealth.
o
It creates a
positive cash flow or helps make more money.
o
It offers a tax
advantage to the borrower.
2. What is a bad debt loan?
·
A loan can be
termed as a bad debt if
o
It increases the
expenses without adding to your net worth.
o
It is used for
consumption or buying depreciating assets.
o
It does not
improve your future cash flow.
o
It does not offer
any tax benefits to the borrower.
3. Examples of a good debt loan
·
Home loan
o
It creates an
asset by building a roof above your head.
o
You save rent and
benefit from rise in its value over time.
o
It also offers you
tax benefits
o
Ensure EMI does
not exceed 45% of your monthly income.
·
Education loan
o
It will help in
knowledge enhancement for you or your child, and pay rich dividends with a good
career.
o
It also offers
tax benefits to the borrower.
·
Business loan
o
It is capital
borrowed to start a business.
o
It will generate
more wealth if the business takes off.
·
Vehicle loan
o
It can be a good
or bad debt, depending on the objective.
o
Buying a basic
vehicle for use is a good debt.
o
Splurging on a
luxury car you can’t afford can be bad debt.
·
Consumer durable loan
o
It can be a good
or bad debt, depending on the objective.
o
Buying an
essential durable for home use is a good debt.
o
Splurging on a
luxury consumer durable can be bad debt.
4. Examples of a bad debt loan
·
Personal loan
o
Money borrowed
for personal expenses is a bad debt.
o
It does nothing
to create value for the borrower.
o
Some determinants
for giving a personal loan are your stability
quotient, house value and location, job
profile, credit history and banking relationship.
o
It should not be
taken to purchase a consumption-based expense, such as a car or TV, or funding
your vacations.
o
Opt for it only
in case of an emergency, and if you are sure that you will be able to repay it
on time.
o
It is mostly used
to pay-off a higher interest rate debt or a large credit card balance.
o
You can also opt
for it to bridge the price of a house and home loan if you are sure that the
price of the house will appreciate fast and generate a positive cash flow.
o
It can also be
opted when you need funds quickly, or do not want to pledge collateral, for
asset-building which will provide good future returns, like a professional
course.
o
However, be
thrifty in your lifestyle till it is fully repaid.
·
Travel and holidaying loan
o
It is also a bad debt as it does not add to your
net worth.
o
It is better to
save before you go on a vacation.
·
Festival loan
o It is also a bad
debt if it only increases your expenses.
·
Pensioner’s loan
o
Some banks
provide loans to senior citizens who receive a regular monthly pension routed
through their bank.
o
These are also bad debts as they eat into your retirement corpus earlier than necessary.
·
Credit card rollover
o
It is the most
expensive and worst form of debt.
o
It should be
availed of only in extreme dire circumstances.
o
In any case,
limit your monthly bill to 15% of your income.