Borrow = Sorrow?

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Investing is important, and we know it. But is it okay to borrow money when we need to purchase something or do something, and do not have the money? Are there some dos and don’ts around borrowing? Let us talk about borrowing (rather than investing) in this article.

We borrow by taking a loan. It is through the loan that the lender gives money to the borrower with the arrangement that the latter will, in instalments, repay the borrowed money with a certain interest and as per an agreed repayment schedule. Four aspects describe a loan:

  1. The principal amount borrowed through the loan
  2. The rate of interest payable by the borrower
  3. The tenure or duration by the completion of which the loan will be repaid
  4. The collateral that must be kept as a security with the lender

Repayment of the loan as per the agreed repayment schedule is obligatory, and prepayment may or may not be an option with every loan. The most common lenders are banks and non-bank finance companies (NBFCs) like housing finance companies. As financial markets develop, loans become more easily available, and we need to be more cautious about our reasons for taking loans.

There can be two types of loans we can avail:

  • Secured Loans, where we as borrowers must pledge some assets as the collateral for the loan. This is used as a security by the lender. If the borrower cannot repay the loan, the lender has the right to recover dues through the pledged collateral. Because of this security for the lender, secured loans carry a lower rate of interest as compared to unsecured loans.
  • Unsecured Loans do not call for any collateral, and as such, are exposed to a higher risk of loss if the borrower defaults on the loan repayment. Such loans carry a higher rate of interest. Personal loans are unsecured loans.

The commonly pledged assets are financial securities like mutual fund investments, shares, bonds, and other assets like property and gold. The amount of loan made available depends on the fair value of the pledged assets, minus a margin that the lender keeps. In the case of unsecured loans, the past relationship with the borrower, the credit score, and other factors are considered by the lender to make the lending decision.

Loans are available for a variety of purposes — housing, vehicle, education, business, etc. Should we take these loans? There are many productive outflows we may need to undertake today, but which will give us good returns in the long term. These are like investing, and since they may involve expenses that are more than our savings, taking these up with the help of loans is advisable, but with some caveats, which we will see later.

For example, education loans are helpful for students to take up higher education independently, without using up the family’s savings, and they come with a tax benefit and a moratorium before the repayment of the loan must start. Normally, loan repayments must begin soon after they are disbursed to the borrowers. But the moratorium on some loans permits the borrowers to legally repay the loan instalments with a defined delay. Similarly, taking a home loan allows us to take up a big investment, without exhausting our savings or liquidating our investments. Home loans come with cheaper rates of interest as the home financed through the loan is pledged as the security, with tax benefits and with the option to prepay without penalty.

Generally, if a loan is taken to realize some useful life goal, it helps the borrower to take a step forward and the rewards from realizing the goal recompense for the cost of servicing the loan. But there are some expenses with no tangible returns, for which loans cannot be justified. These are usually personal loans. Some examples are:

  1. Loans to go on holidays, hold lavish celebrations, or live a flamboyant life
  2. Loans to pay off existing debt, as this leads us into a debt trap
  3. Even loans to make tax-saving investments are not justifiable

Should we take loans even if we have enough money to make the expenditure on our own? This is a choice each one must make by comparing what returns we can earn by investing our money and what we must pay to service the loan after taking into cognizance the tax-saving we get on the interest. Sometimes, it is better to involve a lender when buying a house, as the lender will also critically evaluate the valuation of the house and conduct their due diligence before extending the loan. This can be helpful to avoid bad investments and give us peace of mind. Some of us may just want to avoid debt for peace of mind or other reasons. So, there is no one answer here.

And now for the caveats and the Dos and Don’ts, we must follow when borrowing:

  1. Be conservative: We must borrow within our means, following a loan-to-income relationship thumb rule that our monthly instalments for loan repayment should not exceed 50% of our monthly income.
  2. Be regular: We must repay on time, and prioritize instalments over every other investment. This holds for credit card repayments too. It is good to have the repayments automatically debited from our savings account.
  3. Be judicious: We should not borrow to mindlessly spend or even invest. Repayments on loans are obligatory, while returns from investments may change.
  4. Be protected: When taking a large loan, we can buy term insurance of the same amount as the loan, or even a reducing cover term plan with insurance that matches the balance amount of the loan.
  5. Be logical: We must look for loans that come at lower rates, and switch to lower rate loans if the benefits justify the change. Moving into lower-cost loans is advisable when there is no prepayment penalty on the existing loan, and the existing loan is
  6. Be thoughtful: We must choose the loan tenure carefully. Longer tenure loans come with lower instalments, but in long-term loans, the interest we end up paying is higher. We must take the loan for the shortest tenure we can manage to service from our monthly salary.
  7. Be clear: While we must not take a loan to make investments, we must also not dip into our existing investments, especially those made for our retirement, just to avoid taking a loan. Taking a loan for ‘good’ reasons is the better choice.
  8. Be transparent: When taking a loan, we must appraise our family, as support of the family will be important in ensuring the financial discipline needed to ensure timely repayment of loan instalments.

Loans are a great support when we use them for buying a house or taking up higher education. We should look at borrowing as a facilitator, or a stepping stone, to get closer to our life goals, and hence to our financial goals. We must avoid loans to fulfil any lifestyle goals.

Final words: A loan is our companion, if we take it for the right reasons, and manage it well.