Loans are being offered on phone, through emails and even whatsapp messages, tempting borrowers with easy availability and convenient repayment options. Thanks to technology, you can get a loan within minutes of applying. Why, you may end up with a loan even without applying for one. Buy-now-pay-later (BNPL) companies have mushroomed in the past few years, offering buyers the convenience of deferred payments and interest-free EMIs. Analysts say this trend will only gather pace. Kotak Institutional Equities expects retail loans to grow at 15% year on year till 2024-25. “We are witnessing a disturbing trend of reckless lending and borrowing,” says Sanjay Agarwal, Head, Retail Assets Business of
While borrowing money is necessary, and even recommended in certain situations, one must do this with caution and within reasonable limits. Taking on too much credit will not only rob you of peace of mind, but could also sully your credit score, thereby jeopardising your chances of borrowing in the future. It’s also the first step towards a ruinous debt trap. This week’s cover story looks at some key thumb rules that potential borrowers must keep in mind. Follow these rules to minimise the cost of your loans and become debt free as soon as possible.
Don’t borrow because you can
Just because taking out a loan has become very easy doesn’t mean one should go for it. Financial prudence says that the loan to income ratio must remain below 35% (see graphic). Lenders keep this in mind when they extend you a loan, but further borrowing from other sources can push up the overall liability of the individual. “When they take a loan, very few people foresee a scenario where they will not be able to repay it. Yet, as we saw last year, unforeseen circumstances can push one into that situation,” says Agarwal of Edelweiss ARC.
Before you click on Yes for the preapproved loan from your bank or credit card company, ask yourself if the loan is really important. “You are being sold the idea of unconscious spending. Borrowing for growth is fine, but borrowing for sustenance is not a good idea,” says business coach Rajeev Talreja, founder of Quantum Leap. “A personal loan means you are going beyond your means. If you can’t afford something, you shouldn’t be spending on it,” he adds.
Keep in mind that too much credit is one of the factors that goes into calculating your credit score. So even if you repay on time, the fact that you took the loan will impact your credit score (
see graphic). If you are bogged down with too many loans, consider consolidating your debts under one low-cost loan. A loan against property can be used to repay all other outstanding loans. You could also consider other options such as gold loans and loans against life insurance policies, NSCs or bank deposits.
Prepay as early as you can
Financial planners advise their clients to go for as short a loan tenure as is possible. But sometimes it is necessary to go for a longer tenure. A young person with a low income won’t be able to borrow enough to buy a house if the tenure is 10-15 years. He will have to increase the tenure to 20-25 years to lower the EMI to fit his pocket.
For such borrowers, the best option is to increase the EMI amount every year in line with an increase in the income. Increasing the EMI amount can bring down the tenure dramatically. A 5% increase in the EMI every year will reduce the tenure by more than eight years. Increasing it by 10% every year would end the loan in less than 10 years (
It’s also a good idea to redirect idle cash and lumpy incomes such as bonuses and maturing investments towards prepayment of loans. But here you must take into account the cost of the loan. Prepay the costliest loans first (see graphic) so that your overall interest outgo comes down. When identifying the costly loans to repay, take into account the tax benefits on some loans. Up to Rs.2 lakh interest paid on home loans can be claimed as a deduction under Section 24.
There is no limit on the deduction for interest paid on education loans under Section 80E. These tax breaks reduce the effective rate of interest paid by the borrower (see graphic). Prepayment has a bigger impact in younger loans. If you have taken a 20-year loan and prepay 10% of the outstanding amount in the second year itself, the tenure of the loan will get reduced by three years and six months. But in the fifteenth year, prepayment of 10% will cut the tenure by only seven months (see graphic).
Consider moving to fixed rate
Interest rates have risen in recent weeks, and could go up even further as the RBI tries to rein in inflation. This means loans will become costlier in the coming months. Long-term borrowers are the worst hit when rates go up. Given that rate hikes are imminent, many home loan customers may be considering moving to fixed rate loans. Fixed rate loans are costlier than floating rate loans by almost 100-150 basis points, but they don’t change.
The prevailing rate for floating rate loans is about 7-7.5%, while fixed rate loans charge 7.9-8.5%. This means the EMI will go up after the switch. But experts say one should not switch without doing the math. “If the difference between the floating rate and fixed rate is more than 100 basis points, you don’t stand to gain much from the switch,” says Raj Khosla, founder and Managing Director of MyMoneyMantra. Keep in mind that besides the higher EMI, the customer also has to pay processing fee and other refinance charges when switching to a new loan.
Don’t borrow to invest
We said earlier that borrowing to splurge on wants is a bad idea. Equally bad is the idea to borrow and invest. It is a basic rule of investing that you should invest only what you can afford to lose. Investing borrowed money in volatile assets such as equities can be ruinous if the markets decline. You will not only suffer losses but will be strapped with an EMI as well. Similarly, taking a large home loan to invest in a second or third house may not be a good idea.
It made a lot of sense some 15-20 years ago, when real estate prices were rising at a fast clip of 20-25% per year. But property prices are now either flat or rising very slowly. Loan salesmen often try to lure customers with very attractive quotes. Don’t fall for the flat rate trap. The flat rate is the average interest paid in a year. It is relevant when you pay the entire interest on the loan at the end of the tenure. When you are paying an EMI, the flat rate is not relevant. You should look at the reducing rate of interest. The difference can be huge. If a 3-year loan charges 8.3% flat rate of interest, the effective rate is 15% (see graphic).
Take insurance to cover loans
Buying a house is a major financial commitment. The downpayment usually requires liquidation of all household savings. If you have taken a large home loan, make sure you also have enough life insurance to cover that liability. Buy a term insurance cover equal to the loan amount so that your family is not saddled with unaffordable debt if something happens to you. “In Covid times, we came across several cases where the sole breadwinner of a family passed away, leaving the dependents with a heavy liability.
Lenders do look at such cases with sympathy, but loans can’t be waived,” says Agarwal of Edelweiss ARC. A term insurance plan of Rs.50 lakh will not cost you too much (
see graphic). This insurance cover should be over and above what you might have planned as a replacement of your income. Lenders usually push a reducing cover term plan when they give a loan. But a regular term plan is a better way to cover this liability. It can continue even after the loan is repaid or if you switch lenders. Moreover, insurance policies linked to a loan are usually single premium plans and not as cost effective as regular payment plans.
Don’t dip into retirement kitty
Indian parents can go to any length when it comes to their children’s education. Securing your child’s future is important, but not at the cost of your retirement. Dipping into your retirement corpus to fund your child’s education is not recommended. Students can take loans to pay for their education, but nobody will give you a loan for your retirement needs. Don’t let your emotions compromise your future comfort in retirement.