Neha Pandey Deoras,TNN | Sep 21, 2015, 06.46 AM IST | Times of India
In an ideal world, everybody would have enough money for all his needs. In reality, many of us have little option but to borrow to meet our goals, both real and imagined.For banks and NBFCs, the yawning gap between reality and aspirations is a tremendous opportunity . They are carpet bombing potential customers with loan offers through emails, SMSs and phone calls. Some promise low rates, others offer quick disbursals. Online aggregators help customers zero in on the cheapest loan and banks take less than a minute to approve and disburse loans. However, while technology has altered the way loans are disbursed, the canons of prudent borrowing remain unchanged. It still doesn’t make sense to borrow if you don’t need the money. Or take a long-term loan only to enjoy the tax benefits available on the interest you pay . Our cover story this week lists 6 such rules of borrowing that potential customers must keep in mind. Follow them and you will never find yourself enslaved by debt.
Don’t borrow more than you can repay
Don’t live beyond your means.Take a loan that you can easily repay .”Your monthly outgo towards all your loans should not be more than 50% of your monthly income,” says Rishi Mehra, Founder, Deal4Loans.com.
With banks falling over each other to attract business, taking a loan appears as easy as ABC. But don’t take a loan just because it is available. Make sure that your loan-to-income ratio is within acceptable limits. Take the case of Hyderabad-based Phani Kumar, who has been repaying loans right from the time he started working.
It started with two personal loans of `5 lakh six years ago. Then, he was paying an EMI of `18,000 (or 40% of his take home). Kumar took a car loan of `5.74 lakh in 2012, adding another `12,500 to his monthly outgo. Last year, he took a third personal loan of `8 lakh to retire the other loans and another top-up loan of `4 lakh. Today, he pays an EMI of `49,900, almost 72% of his take-home pay .
If your EMIs gobble up too much of your income, other critical financial goals, like saving for retirement or your kids’ education, might get impacted.Retirement planning is often the first to be sacrificed in such situations.
Keep tenure as short as possible
The maximum home loan tenure offered by all major lenders is 30 years. The longer the tenure, the lower is the EMI, which makes it very tempting to go for a 25-30 year loan. However, it is best to take a loan for the shortest tenure you can afford. In a long-term loan, the interest outgo is too high. In a 10-year loan, the interest paid is 57% of the borrowed amount. This shoots up to 128% if the tenure is 20 years. If you take a `50 lakh loan for 25 years, you will pay `83.5 lakh (or 167%) in interest alone. “Taking a loan is negative compounding. The longer the tenure, the higher is the compound interest the bank earns from you,” warns financial trainer P .V . Subramanyam.
Sometimes, it may be necessary to go for a longer tenure. A young person with a low income won’t be able to borrow enough if the tenure is 10 years. He will have to increase the tenure so that the EMI fits his pocket. For such borrowers, the best option is to increase the EMI amount every year in line with an increase in the income.
Assuming that the borrower’s income will rise 8-10% every year, increasing the EMI in the same proportion should not be difficult. If a person takes a loan of `50 lakh at 10% for 20 years, his EMI will be `48,251. If he increases the EMI every year by 5%, the loan gets paid off in less than 12 years. If he increases the EMI by 10% every year, he would pay off the loan in just nine years and three months.
Ensure regular repayment
It pays to be disciplined. Wheth er it is a short-term debt like a credit card bill or a long-term loan for your house, make sure you don’t miss the payment. Missing an EMI or delaying a payment are among the key factors that can impact your credit profile and hinder your chances of taking a loan for other needs later in life. Never miss a loan EMI. In an emergency , prioritise dues. You must take care never to miss your credit card payments because you will not only be slapped with a non-payment penalty but also be charged a hefty interest on the unpaid amount. If you don’t have the money to pay the entire credit card bill, pay the minimum 5% and roll over the balance.At an interest of 24-36%, credit card debt is the costliest loan you will take.
Don’t borrow to splurge or to invest
Never use borrowed money to invest. Ultra-safe investments like fixed deposits and bonds won’t be able to match the interest you pay on the loan.And investments that offer higher returns are too volatile. If the markets decline, you will not only suffer losses but will be strapped with an EMI as well. There was a time when real estate was a very cost-effective investment. Housing loans were available for 7-8% and real estate prices were rising 1520%. So it made a lot of sense to buy a property with a cheap loan. Now tables have turned. Home loans now cost around 10% while property prices are rising by barely 4-5%. In some pockets they have even declined.
Similarly, avoid taking a loan for discretionary spending. You may be getting SMSs from your credit card company for a travel loan, but such wants are better fulfilled by saving up.”It’s not a good idea to take a personal loan for buying luxury watches and high-end bags,” says Vineet Jain, Founder of LoanStreet.in. If you must go on a holiday, throw a party or indulge in luxury shopping, start saving now.
On the other hand, taking a loan for building an asset makes eminent sense.For instance, Mumbai-based Sandeep Yadav junked plans to go on a foreign holiday and instead used the money for the downpayment of a house, bringing down the overall loan requirement.
If you take a large home or car loan, it is best to take insurance cover as well. Buy a term plan of the same amount to ensure that your family is not saddled with unaffordable debt if something happens to you. The lender will take over the asset (house or car) if your dependents are unable to pay the EMI. A term insurance plan of `50 lakh will not cost you too much.Banks push a reducing cover term plan that offers insurance equal to the outstanding amount. However, a regular term plan is better. It can continue even after the loan is repaid or if you switch lender. Moreover, insurance policies that are linked to a loan are often single premium plans. These are not as cost effective as regular payment plans.
Keep shopping for better rates
A long-term mortgage should never be a sign-and-forget exercise. Keep your eyes and ears open about new rules and changes in interest rates. The RBI is planning to change the base rate formula, which could change the way your bank calibrates its lending rates. Keep shopping around for the best rate and switch to a cheaper loan if possible. However, the difference should be at least 2 percentage points, otherwise the prepayment penalty on the old loan and processing charges of the new loan will eat into the gains from the switch. Also, switching is more beneficial if done early in the loan tenure.
The same applies to prepayment of loans. The earlier you do it, the bigger is the impact on loan tenure. The RBI does not allow banks to levy a prepayment penalty on housing loans but they may levy a penalty on other loans. Some lenders do not charge a prepayment penalty if the amount paid does not exceed 25% of the outstanding amount at the beginning of the year.
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