Financial experts often advise us to live within our means. But given that most of us are impatient to improve our lifestyles, staying off borrowings is difficult. Borrowings also make sense in an inflationary economy where money rapidly loses value over time. But how can you strike that balance between spending sleepless nights over debt and being a Scrooge who lives in squalor?
Loan eligibility
In India, lenders allow you to take on EMIs of up to 50 per cent of monthly disposable income, after adjusting for any fixed outgo. For example, if Madhu earns a take-home pay of ₹1 lakh a month and pays an EMI of ₹10,000 on a car loan, the lender may allow her to take on an additional EMI of slightly less than ₹40,000, for a home loan. If she’s seeking a 15-year loan at 9 per cent, this translates into an eligibility of about ₹40 lakh.
But remember that banks have a business interest in stretching your loan eligibility.
When you take on EMIs that eat up 50 per cent of your disposable income, it severely impairs your ability to save towards other future goals (such as retirement), forces you to defer other purchases, and robs you of the flexibility to sail through ups and downs.
Do your own calculation on loan affordability instead of maxing out your eligibility.
Deduct your living expenses, current EMIs and compulsory savings of 15-20 per cent from your income, to arrive at a comfortable EMI.
Appreciating assets
For leverage to make financial sense, the return you earn on the leveraged asset should be higher than your borrowing costs. Given high interest rates for retail borrowers in India, it is often hard to find assets that fetch you a higher return than the interest rate on your loan.
But you can control the damage that borrowings inflict on your net worth, by using them to invest in appreciating, rather than depreciating, assets.
Property, pieces of land or added educational qualifications, for instance, are appreciating assets that are likely to earn you capital appreciation or higher income over time.
An SUV, a double-door fridge, a smartphone or a home theatre system are depreciating assets that lose value the moment you purchase them.
When you borrow to buy such goods, there’s a double whammy on your wealth from the interest outgo as well as the loss in the value of the asset.
Borrowing to fund consumption or experiences such as holidays is even worse, because there’s no asset to show for the liability you’ve taken on. Therefore, if you’re keen to spend on big-ticket consumption or experiences, you should postpone the spending until you’ve saved enough towards the goal.
Don’t bet on big increments
We Indians are used to high income increases every year.
This makes it tempting to stretch ourselves to sign up for higher monthly instalments than we can afford, as we believe income growth will reduce the burden over time.
But if that calculation made a lot of sense even five years ago, when inflation was running at 7-8 per cent and annual increments at 10-12 per cent, both are no longer true.
With salary increases across many sectors moderating to 5-6 per cent, don’t expect the burden of a large EMI to reduce materially over time.
With variable compensation leading to volatility in pay, and pink slips becoming more prevalent in India, it is best to take on loans that you can comfortably afford with your current earnings.
Opt for higher EMIs
When evaluating loans, we often over-focus on the size of the EMI we’re taking on. But this can blindside you to the total liability. One way lenders often make EMIs more ‘affordable’ for you is by offering you a longer tenure. But longer tenures benefit lenders rather than borrowers, because the interest payments compound over a longer period.
Take the case of a ₹50-lakh home loan at 9 per cent interest. For a 15-year tenure, the monthly EMI works out to ₹50,713 and you end up repaying the bank a total of ₹91.28 lakh at the end of 15 years. Stretch the tenure to 20 years, and while your EMI falls to ₹44,986, the total amount you would have to pay becomes ₹1.07 crore. With a 20-year loan, you end up paying an interest of ₹57.9 lakh, compared with ₹41.2 lakh in the 15-year loan.
This is also why you must always negotiate with your lender to increase your EMIs (not tenure) when interest rates rise, and prepay your loan as soon as you can.
Always shop for better rates
Once we’ve taken on EMIs, we often put the loan on autopilot, paying the EMIs without re-evaluating if there are better deals available in the market. But Indian banks today offer a range of floating-rate options to borrowers, linked to different benchmarks — the base rate, MCLR and the RBI repo rate.
Often, lenders woo new borrowers with their best rates while older ones continue to pay through their nose. This makes it important for you to closely track the rates across different benchmarks and lenders, and jump ship promptly when you see a big saving.