Loans: follow these 6 rules to minimize the cost of your loans, get out of debt as soon as possible
Loans are offered by phone, email and even WhatsApp, tempting borrowers with easy availability and convenient repayment options. Thanks to technology, you can get a loan within minutes of applying. Why, you can end up with a loan even without applying for it. Buy-it-now and pay-later (BNPL) companies have proliferated in recent years, offering buyers the convenience of deferred payments and interest-free EMI. Analysts say this trend will only accelerate. Kotak Institutional Equities expects retail lending to grow 15% year-over-year through 2024-25. “We are seeing a worrying trend of reckless lending and borrowing,” says Sanjay Agarwal, head of Retail Assets business at
Although borrowing money is necessary and even recommended in certain situations, it should be done with caution and within reasonable limits. Taking on too much credit will not only rob you of your peace of mind, but could also hurt your credit score, jeopardizing your chances of borrowing in the future. It is also the first step towards a ruinous debt trap. This week’s feature article looks at some key rules that potential borrowers should keep in mind. Follow these rules to minimize the cost of your loans and get out of debt as soon as possible.
Don’t borrow because you can
It is not because taking out a loan has become very easy that you have to start. Financial prudence says that the loan-to-income ratio should stay below 35% (see chart). Lenders keep this in mind when giving you a loan, but further borrowing from other sources can increase the individual’s overall liability. “When taking out a loan, very few people foresee a scenario where they won’t be able to repay it. Yet, as we saw last year, unforeseen circumstances can push someone into this situation,” says Agarwal of Edelweiss ARC.
Before you click yes on the pre-approved loan from your bank or credit card company, ask yourself if the loan is really large. “You are being sold the idea of unconscious spending. Borrowing for growth is good, but borrowing to support yourself is not a good idea,” says Rajeev Talreja, business coach, founder of Quantum Leap. “A personal loan means that you go beyond your means. If you can’t afford something, you shouldn’t spend on it,” he adds.
Keep in mind that too much credit is one of the factors that go into calculating your credit score. So even if you repay on time, the fact that you took out the loan will impact your credit score (
see graphic). If you’re bogged down with too many loans, consider consolidating your debts into one low-cost loan. A property loan can be used to pay off all other outstanding loans. You can also consider other options such as loans on gold and loans on life insurance policies, NSCs or bank deposits.
Prepay as soon as you can
Financial planners advise their clients to keep the loan term as short as possible. But sometimes it is necessary to opt for a longer term. A low-income young person will not be able to borrow enough to buy a house if the tenure is 10 to 15 years. He will have to increase the tenure to 20-25 years to lower the EMI to fit in his pocket.
For these borrowers, the best option is to increase the amount of EMI each year as income increases. Increasing the amount of EMI can significantly reduce occupancy time. A 5% increase in the EMI each year will reduce tenure by more than eight years. Increasing it by 10% each year would end the loan in less than 10 years (
It’s also a good idea to redirect idle cash and lump sum income such as bonuses and maturing investments to early repayment of loans. But here you need to consider the cost of the loan. Pay off the most expensive loans first (see chart) so that your overall interest expense goes down. When identifying expensive loans to repay, consider the tax advantages of certain loans. Up to Rs.2 lakh interest paid on home loans can be claimed as a deduction under Section 24.
There is no limit to the deduction of interest paid on student loans under Section 80E. These tax advantages reduce the effective interest rate paid by the borrower (see graph). Early repayment has a greater impact on younger loans. If you took out a 20-year loan and prepaid 10% of the outstanding amount in the second year, the loan term will be reduced by three years and six months. But in the fifteenth year, a prepayment of 10% will only reduce the tenure period by seven months (see graph).
Consider switching to fixed rate
Interest rates have risen in recent weeks and could rise further as the RBI tries to contain inflation. This means that loans will become more expensive in the coming months. Long-term borrowers are the most affected when rates rise. With rate hikes looming, many home loan customers may be considering switching to fixed rate loans. Fixed rate loans are more expensive than variable rate loans by almost 100 to 150 basis points, but they don’t change.
The going rate for variable rate loans is around 7-7.5%, while fixed rate loans charge 7.9-8.5%. This means that the EMI will increase after the change. But experts say don’t change without doing the math. “If the difference between the floating rate and the fixed rate is more than 100 basis points, you don’t have much to gain from the change,” says Raj Khosla, founder and managing director of MyMoneyMantra. Keep in mind that in addition to the higher EMI, the customer must also pay processing fees and other refinance fees when switching to a new loan.
Don’t borrow to invest
We said earlier that borrowing to splurge is a bad idea. Equally bad is the idea of borrowing and investing. It is a basic rule of investing that you should only invest what you can afford to lose. Investing borrowed money in volatile assets such as stocks can be ruinous if the markets go down. Not only will you suffer losses, but you will also be tied to an NDE. Likewise, taking out a large home loan to invest in a second or third home may not be a good idea.
This made a lot of sense 15-20 years ago when house prices were rising at a rapid rate of 20-25% per year. But property prices are now either flat or rising very slowly. Loan sellers often try to entice customers with very attractive quotes. Don’t fall into the flat rate trap. The flat rate is the average interest paid in one year. It is relevant when you pay the full interest on the loan at the end of the term. When paying for an EMI, the flat rate is irrelevant. You should look at the interest rate reduction. The difference can be huge. If a 3-year loan has a fixed interest rate of 8.3%, the effective rate is 15% (see graph).
Take out insurance to cover the loans
Buying a home is a major financial commitment. The deposit generally requires the liquidation of all household savings. If you have taken out a large home loan, also make sure you have sufficient life insurance to cover this liability. Buy term insurance coverage equal to the amount of the loan so your family won’t be saddled with unaffordable debt if something happens to you. “During Covid times, we have encountered several instances where the sole breadwinner of a family has died, leaving dependents with a heavy burden.
Lenders view these cases sympathetically, but loans cannot be canceled,” says Agarwal of Edelweiss ARC. A temporary insurance plan of Rs.50 lakh will not cost you too much (
see graphic). This insurance coverage must be greater than what you could have expected to replace your income. Lenders usually push for a reduced coverage term plan when they make a loan. But a regular term plan is a better way to cover that liability. It can continue even after the loan is repaid or if you change lenders. Additionally, loan-linked insurance policies are usually single-premium plans and less cost-effective than regular payment plans.
Don’t dive into the retirement kitty
Indian parents can go all the way when it comes to raising their children. Securing your child’s future is important, but not at the expense of your retirement. It is not recommended to dip into your pension fund to finance your child’s studies. Students can take out loans to pay for their education, but no one will give you a loan for your retirement needs. Don’t let your emotions compromise your future comfort in retirement.