By Uma Shashikant | 30 Mar, 2015, 08.10AM IST | Economic Times
A common crib against the younger generation has to do with the habit of borrowing. Now pause to consider the most prized asset in the portfolio of the complaining elder. It is likely to be a house, bought, of course, with a housing loan. Without a home loan, most of us would not be able to own property. However, many of us also overdo it when it comes to banishing loans from our lives.
A borrower takes money not from the lender, but from his future income. The risk comes from the unknown future and the change the loan can make in it. A boastful zero-loaner is likely to have a stable income and routine savings which fuel such righteousness. For the rest, borrowing may be unavoidable.
Loans differ based on the need they serve. A loan that is taken to tackle a liquidity crunch is a mere arrangement. When a company borrows from the bank to pay salaries, it is meeting an immediate need for cash, which will flow in once the sales are realised. A hand loan from a friend to contribute to a farewell party is an arrangement of trust, to return that money with the next ATM withdrawal. A loan that is taken for buying a house or any other long-term asset is a charge on future income and is a funding contract. A lender agrees to fund the asset on your behalf and structures a repayment from you keeping the asset as collateral. A loan taken to punt on the future value of a commodity or index is a leveraged speculative position. It can turn either way. So, find out and understand what your need is before taking a loan.
Habitual hand loan borrowers typically lose friends and contacts. Research on the psychology of borrowers points out that they may actually develop a ‘blind spot’ over time, pushing the memories of loan to the background. While lenders resent the loan made to a friend as repayment gets delayed, the borrower either convinces himself that it is not his fault, or feels a sense of relief that the lender will no longer chase him for repayment. People are known to recall what they lent much more than what they borrowed.
Always see hand loans as liquidity arrangements. They come without interest and are based on trust. The faster you repay these loans, the better it is. If you find yourself taking too many hand loans and struggling to repay them, you may not have a liquidity problem, but inadequacy of income. Your spending needs habitually exceed what you earn and unless you find ways to augment your income, you may find yourself in a debt trap, with no friends to bail you out.
Loans to buy assets are long-term formal contracts. Borrowers own the asset even as they repay. The lender is also secure as the asset can be repossessed and sold in the event of a default. In the case of a home loan, borrowers typically pitch in with a substantial amount of their own. This reduces the probability of default even further. That is why providing a loan against property is good business. However, property loans have, over time, turned into speculative bets on housing prices. Thus, asset-based lending has turned into leverage that risk multiplies.
The sub-prime defaults that led to the global financial crisis of 2008 originated with loans that were enabling home ownership, but were sold and bought with the assumption that housing prices would continue to rise.
Consider one of the popular structures, the interest-only loan. The borrower takes a loan to buy property, but pays only interest for the first three years. This makes the loan look inexpensive and affordable to the simple borrower. It is attractively designed for the speculator, who could sell off in three years to repay the loan. The simple borrowers underestimate the repayment burden in later years. They are driven by overconfidence that simply extrapolates the present. If the borrower fails to see the loss of jobs and income, the speculators assume that the prices will only move up. There is an auto feedback cycle in play when assets are funded with borrowing.
Housing prices respond to demand; demand moves up when loans are easy to get; and loans are more and more viable as the asset values go up. An asset bubble is created and leveraged funds push up asset prices. The collateral damage is huge when asset prices fall. The borrower defaults since the asset he bought with the loan has lost value; the lender gets wiped out when he is unable to resell the asset in a falling market to cover the value of the unpaid loan. A leveraged position runs the risk that asset prices may turn unexpectedly, creating a chain of defaults.
The loan to avoid is speculative leverage. One feels smart while borrowing on the margin and betting on the stock market. Few rounds of winning also boost confidence, but one unexpected correction is enough to wipe off a good chunk of capital. Without the emotional intelligence to manage the capital carefully and take losses on the chin, leveraged speculation can be ruinous.
However, not all borrowing is harmful. If the borrowing creates an asset, the asset meets a need or is useful, and if the repayment is well within the stable income of the borrower, there is no problem. Not all loans need to meet the rigid conditionality of creating an economically valuable asset, such as a home or a business. Simple loans for an expensive gift, a holiday or a car, are also fine as long as they do not stretch the repayment capability of the borrower. Such loans have to be evaluated for the opportunity cost since a higher EMI means a lower SIP. Loans, by definition, are restrictive as they are a fixed charge on the future income. Keeping such ‘low value’ loans to less than 20% of the post-tax income is a good thumb rule. Asking if the routine saving is at least equal to the EMI is also a good check.
Between a high stake bet and the perilous hand loan that kills relationships, is a wide space of responsible borrowing that can help build assets, enjoy the perks of a steady income and indulge in some instant gratification. There is no need to be too hung up about borrowing.
The author is Managing Director, Centre for Investment Education and Learning
Source : http://goo.gl/481Sdw