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One of the golden rules about managing your personal finances efficiently is – live within your means! This means, don’t overspend your hard-earned money, and stay away from having to borrow.
I know, it is easier said than done – as we all face situations in life that may require us to borrow.
However, if borrow you must, do it responsibly. If not, there is a risk that your single loan may quickly lead to you getting debt-trapped. If not debt-trapped, borrowing would certainly mean that you would not be able to save / invest the interest amount that you would pay the lender, which may ultimately cost you any financial objectives you may have set for yourself – whether it is retiring at an early age, or funding for your child’s higher education in a premier institution or something else!
This article discusses some of the common issues faced / mistakes made by people when it comes to their loans or borrowings.
At times, people borrow even though they have the funds necessary to buy the desired goods. The motivations to do that may be many! One such motivation could be the attraction of equated monthly instalment (EMI) facility offered by the lender. For example,
Remember – EMIs are convenient. But they typically involve a high interest cost for you! So minimise the period of your borrowings.
There may be other motivations too. For example, if you are expecting to earn a much higher investment return on your investments (say 13% p.a.), then by going for the EMI facility at 10% p.a. would effectively mean that you are a net gainer – as you earn 13% p.a. return on the amount you invest, but pay only 10% p.a. to the lender through the EMIs you pay! This is referred to as the ‘leverage’ effect.
However, this assumes that you would definitely earn an investment return of 13% p.a. What if you don’t earn that and instead earn only say 8% p.a.? You would be a net loser in such a situation! So although leveraging may be beneficial to a certain extent, but shouldn’t be overdone to avoid losing money.
Considering this, in most circumstances, you may be better off buying the goods from your available funds, instead of going for the borrowing through the EMI facility offered.
Many a times when we borrow – whether housing loan or personal loan or car loans etc., we tend to focus only on the rate of interest charged by the lender, in deciding which lender to avail the loan from.
However, there may well be other costs involved. These typically include processing fees, stamp duty and other external advisors’ fees (if necessary). Similarly, you may also need to carefully consider other features of your loan / charges that may become payable during the course of your loan. For example:
At the same time, there may also be certain income tax benefits available on certain types of loans.
It is only after considering all such features, costs / benefits, along with the rate of interest charged, should one decide on the lender to avail the loan from.
Several lenders offer loans at ‘attractive interest rate’ (say at 2% p.a.) against the fixed deposits that you may have with the lender. Many find such a facility attractive thinking that:
However, in such an arrangement, what the lender is really doing is offering a loan at an interest rate that is equal to the interest rate on the FD + 2% p.a. Which means, if you have FDs placed several years ago, earning an interest of say 8% p.a., the interest you are effectively getting charged on your loan is 10% p.a. and not 2% p.a.
In a scenario that the interest rate charged by the lender on a loan which is not backed by any FD, is low – say at 7% p.a. you may be better off not availing the facility to borrow against your FD. Instead, liquidating your FD (assuming the early liquidating charges are low) and borrowing a lower amount instead may be financially more rewarding.
Consider the true costs involved in loans backed by FDs and the costs involved in alternative arrangements before deciding the right approach to adopt!
When availing a home loan, the biggest hurdle one faces is to decide whether to go for a fixed interest or a floating interest.
The fixed interest loan, if offered by the bank, guarantees the interest payable on the loan for the entire tenure of the loan (e.g. 15 or 20 years). Even if the interest rates increase during this period, you will not be required to pay additional amounts or pay the EMIs for any longer period than originally agreed.
On the other hand, the floating rate loans mean that as the interest rates change, you will be charged the ‘new’ interest rate and therefore your loan may continue for a longer period than originally agreed, if your EMIs remain constant.
Typically, the fixed interest rates are higher than the floating rates, as the bank needs to be compensated for the risk that they are undertaking – the risk of interest rates going up resulting in their inability to charge the same to you. Naturally, home loan seekers tend to get attracted to a floating interest rate, as this may be lower than the fixed rate.
However, apart from considering only the interest rates on fixed and floating rate options, one may need to also consider whether during the tenure of the loan the interest rates are expected to go up or come down, and by how much. This is not easy to ascertain, as nobody can really predict the direction of interest rates in the future.
In such circumstances, depending on the difference between the two rates, it may be better to go for a fixed interest rate home loan (if offered by your bank). Under this option, you are protected if the interest rates go up in the future. If the interest rates fall significantly, you may also be able to adopt one of the following approaches:
None of these approaches are full-proof and would certainly involve additional costs. However, unless the difference between the fixed and floating interest rates offered by your bank is significantly large, it may be preferable to go for a fixed interest loan – at least that gives you the peace of mind!
We all use credit cards. They provide a convenient avenue to pay for our purchases and pay for them only later - approximately one month from the date of the purchases. We also get attracted to the other features of our credit card – e.g. the reward points, the numerous discount offers etc.
So far so good!
However, when it comes to paying for our purchases, many a times, we select the ‘minimum amount to pay’ option on the credit card statement, rather than paying the full amount. At times, the credit card providers may also offer you ‘EMI’ facility for certain large purchases, and many even opt for this.
By doing this, essentially, we are ‘rolling over’ the unpaid amounts to the following month – i.e. effectively taking a ‘loan’ for the amount on our credit card. This is, probably, the most expensive loan one can avail – with interest rates charged going above 25% - 30% p.a.! If you continue to roll-over your previous month’s credit card balances to the following month, very soon you would simply fall in a debt-trap.
So do yourself a favour! Never roll-over credit card balances. Use credit cards only as a convenient mechanism to pay for your purchases, and not as something that you can borrow from!
How do banks / lenders decide on the interest rate to charge you on the loan? Or even decide whether or not to grant you a loan? Amongst other things, they consider your ‘credit score’. The higher the credit score, the higher your chances of getting the loan and that too at a lower interest rate! So what is the credit score and how do you get a high credit score?
In India, the Credit Information Bureau (India) Limited (“CIBIL”) assigns credit scores to all. In assigning credit scores to you, CIBIL considers the following:
All your loan / credit related information is available to CIBIL from the banks / lenders from whom you availed the loans in the past. Thus, to ensure a good (high) credit score, you should really make sure that you don’t avail too much loan / credit especially the ‘unsecured’ ones; not to avail loans too frequently; and most importantly pay your dues on time without any delay / roll-over of the credit to the following month on the credit cards!
At times, people mortgage their residential property in order to avail high amount of loan – e.g. to start a new business, or to expand the existing business or even to meet the expenses related to your daughter’s marriage. Unless you have the ability to re-pay it on time, there is a significant risk that the loan against residential property may lead to you losing your most prized possession – your home!
Even if you have the ability to re-pay the loan on time, there is always the risk that you may not be able to do it, and consequently lose your home.
The last thing you want is to not have a roof over your head! So before you mortgage your residential property, think really very hard.
Borrowing responsibly is very essential to ensure a healthy financial future for oneself. One should be fully familiar with the nuances of borrowing before availing any loans. At the risk of repeating, it is worth re-stating the obvious – Only borrow if you must, and do it responsibly!