Loans & Why we Borrow?

Loan – one word that has helped millions prepone their dreams.

Be it owning a house, buying a car, getting higher education or even gifting a diamond ring to your wife! Loans have been helpful no doubt.

Unsurprisingly, this help comes at a cost – interest.

But that is how this financial product is designed to be and there is nothing wrong about it. You want to buy something you can’t afford to pay for today? Sure… you can have it. Just pay some extra interest. Fair and square.

But if people can’t afford something today, why can’t they just wait to have more money? In a twist to original words by Thomas Jefferson,

“Why do these people want to spend the money before even they have it?”

So the question is…

 

Why do People Borrow Money?

Its easy for me to say that you should never borrow.

But for most people, that’s not possible. Nobody borrows out of their desire to help banks / lenders earn interest. 🙂 Isn’t it?

In most cases, people borrow when they need to.

Primarily, its to…

1. Buy some asset (house – if you consider it one; land, even car, etc.)
2. Increase one’s earning potential (higher education)
3. Pay for emergencies (like death or medical ones)
4. Live beyond their means (…you know what I mean)

Lets take up all four of these points in reverse order:

 

Number#4

This should be avoided at all costs.

Its true that you get one life and you need to live it up ‘today’. But don’t use this logic to screw yourself financially.

If you can’t afford to buy a Rs 75,000 mobile phone from your own pocket, then taking a loan to buy it won’t help you. Such showoff (when you can’t even afford it) will only push you deeper into financial misery.

There can be many other examples. Think about it (hint: credit cards).

And this quote by James Basford truly summarizes everything:

The man who never has money enough to pay his debts has too much of something else.

And avoid living beyond your means as much as possible.

 

Number#3

This one is about being in a situation where you don’t have enough money to pay for the unexpected and unplanned events (like repairs, medical emergencies or even death). Some of these risks can be covered by proper insurance (like life, health, critical illness, accident, vehicles, etc.).

But if those insurance covers aren’t in place, you will be forced to borrow.

You can’t avoid it. Though you could have if you had bought insurance earlier. I seriously recommend you read why buying a health insurance can protect your wealth.

Many emergencies cannot be insured. If you need to borrow for such ones, you once again can’t do anything about it. One example is when you can’t say no to your close relatives.

 

Number#2

This one is about funding higher education costs.

The rising fees have led to the growing need for loans for higher education.

Infact, education loans are slowly turning into the new ‘housing loans’. Most middle class children can’t get a decent higher education without loans. Sad but true…

From parent’s perspective, views might differ from one person to other. Some people want to fully fund their children’s higher education, even if it means sacrificing their future financial security. Others want their children to share the burden. And many have a view similar to those in developed nations, where there are no societal expectations that parents will support children financially.

An education loan can help bridge the gap between required amount and money contributed by parents (or self if earned earlier).

It won’t be wrong to consider education loans as sort of good loans. In a way, its an investment you make to potentially increase your future earning power – which is a fair deal I would say.

But people need to be careful about taking education loans. Taking a loan to study in good colleges is fine. But given the kind of shitty colleges there are these days, there are high chances that the degree you get might not be much useful. Getting a loan-funded degree from such colleges may put you in a terrible situation – a big loan to repay and a worthless degree that can’t even get you a decent job.

Even countries like the U.S. are facing a big student loans crisis. In fact, if statistics are to be believed then the Americans owe over $1.2 trillion in student loan debt. To understand the enormity of that figure, compare it with India’s GDP that stands a little over $2 trillion. Unable to repay their education loans, a lot of Americans are resorting to student loan refinancing at lower rates. I don’t know whether India’s education loan portfolio will achieve such gargantuan proportions in near future or not, but authorities must ensure that we don’t walk the path of US student loan crisis.

 

Number#1

Finally, this one is about taking loans to buy assets. Can be for both appreciating as well as depreciating assets.

Buying a house on loan is more of a necessity. Most people don’t have spare Rs 30-50 lacs to just go out one evening and buy a house. Even managing a downpayment of 20% is a tough task for most people.

Buying a house for personal use is fine. I know many people will share mathematical logics about staying on rent and stuff. But if you want peace of mind, having one ‘self-owned’ primary residence is the way to go. If not today, then maybe later. But it helps.

As for investing in real estate is concerned, it turns out that its not a very great investment as many people believe it to be – there is a popular post on Stable Investor about this topic. Please refer to it here.

Buying property on loan is fine. But what about taking loans for depreciating assets like car? You might take it. For many people, buying a car is a need that can’t be postponed. So go ahead and take a loan for it. But try to keep the loan amount to minimum. Also try to pay it off quickly. No point paying more interest on something that is losing value every single day.

 

Managing Loans Smartly

Taking loans is one thing and managing them smartly is another.

Some people are really smart about how they manage their debts. Their proper loan management helps them add real value to their financial portfolio.

For example (and I am using approximate numbers here), if you take a home loan of Rs 50 lac @ 9% for 20 years, your total interest outgo will be about Rs 58 lac. So in total, you pay Rs 1.08 Cr (= Rs 50 lac + Rs 58 lac). EMI is about Rs 44-45K.

But if you are ready to shell out slightly higher EMI of Rs 50-52K, then you loan tenure can come down to 15 years and total interest to about Rs 41 lac. So in total, you pay Rs 91 lac (Rs 50 lac + Rs 41 lac). That’s a saving of about Rs 15-17 lacs on total interest paid. In terms of loan principle, it translates into 30-35%.

These are broad numbers. But clearly show how just a few thousand more every month can be a smart money move when dealing with loans of long tenure.

Those who are not familiar with how loans really work, sadly end up messing their personal financial situations. I will write about this topic in detail some other time.

Now if you have multiple loans, then you need to understand the real nature of each one of them, prioritize them and allocate resources to repay them from your income accordingly. Here, I am not saying that you shouldn’t pay the legally required EMI for each of the loans.

But if you have additional funds that can be used to clear off some of loans, find the most suitable ones (generally high interest loans) to clear off first. Talking of surplus, if you are thinking of investing elsewhere before repaying the loan, please read this – Payoff Loans or Start Investing.

To conclude, I think no one would take loans if they had all the money they genuinely needed.

But since most people don’t have that kind of money, people will continue to borrow. Its just suffice to say that you need to be sensible about your borrowings. More so in case of large loans. I leave you with a hilarious quote by Earl Wilson:

Today, there are three kinds of people: the have’s, the have-not’s, and the have-not-paid-for-what-they-have’s.