Should we take loans?

Loans are good as long as they create assets, increase net worth and payouts are managed within 40-50% of monthly income

Loans are available for a variety of reasons. We take loans for buying a property, getting a car, educating our children, purchasing gold, going on a holiday, spending on luxury items or simply supplementing our income. Invariably it is for satisfying our wants and needs.

But we should seriously consider whether the want is essential or whimsical. We find that often desires take the better of us and we splurge on discretionary spending. Should we take loans to indulge?

Loans come at a cost

Loans come at a cost and the nature of the loan decides its price. Moreover, the loan amount is meant to be paid back with interest within a predetermined time period. There cannot be any lapses as delay in payment would mean additional charges with penalties.

There could also be legal action and physical recovery if the default in payment is prolonged. With such stiff conditions and adverse possibilities, why should we take a loan?

Loans create stress

Loans also disturb our monthly budget as the same resources have to be used to make the monthly repayments. It can also create stress as deadlines have to be met. And we continue to carry this burden over a fair length of time till the loan is fully paid. Should we therefore not think a fair number of times before we sign on the loan documents?

Mortgaging our future

Most certainly yes, as we are mortgaging our future to the lender. The reason for the loan has to be strong and compulsive. There should be creation of an asset with the loan money so that our hard earned money is well spent. Our net worth should improve or else we might be staring at a financial crisis.

The question ‘why do we take loans’? seeks an answer.

It is linked to our personality characteristics, thought process and financial prudence. The smart individual would strengthen his finances by acquiring property with a home loan. Over time the property would appreciate in value and would cover the loan amount.

A productive asset would generate returns and increase the net worth. It would be a judicious decision and loan money well spent. You would also be able to save on taxes considering the deductions permissible on payment of principal and interest on home loans.

But here, there is a need for caution as the home loan amount should not be too ambitious. The EMIs (equated monthly installments) together with your monthly expenses should not in any case be more than 50% of your monthly income.

Any amount in excess is likely to disturb the monthly budget and lead to possible default. Therefore, a good loan can turn bad if the payouts exceed the repaying capacity.

The wealth effect

Sometimes we get carried away by our wealth. Wealth effect is nothing but appreciation in the value of assets such as homes or stocks.

This increase in wealth gives us a false sense of security. We start to save less and look to consume more.

Such an attitude leads to meaningless consumption. To satisfy our desires we go for personal loans and consumer loans. Our use of credit cards also increase and slowly we go deep into mindless consumption. It might give us temporary satisfaction and be stress busters but the flip side may not be encouraging.

Personal loans and credit card dues are unsecured and therefore very costly. There is no asset creation which can absorb future shock in case of defaults in payment. This debt becomes a burden over the long run.

The cost of a holiday or a consumer item bought by taking unsecured loans goes up manifold. The interest paid over the tenure of the loan makes the acquisition unviable. We need to factor in this aspect when we avail the loan.
 
Financial stress can be very damaging as it can play havoc with our future. Consumption habits should preferably not be met through loans but by making provisions from the monthly income. In this way our future plans would not be disturbed. A wise man secures his financial future by avoiding undesirable expenses. Once there is a sufficient buffer of savings and investments, there can be scope for indulging in tempting luxury goods and holiday trips.

The pleasures derived would also be much more as there would not be the lurking fear of tight payment deadlines to be met. Prominent self made individuals caution people against reckless expenses and costly indulgences.

Loans are good as long as they create assets, increase our net worth and their payouts are managed within 40-50% of our monthly income. Our future should not be held to ransom by rash financial decisions for some momentary pleasures in the present. Financial indiscretion has ruined many an individual.

It is for this reason that credit counselling centres are established for guiding consumers of loans to assess realistically their financial position.

Should we still be taking loans?
We need to ask ourselves this question in all sincerity to get an honest answer.

(The writer is a banking consultant)