Financial experts' guide on how to borrow wisely

Striking a balance between spending sleepless nights over debt and being niggardly involves many intricacies

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Financial experts often advise us to live within our means. Yet, given our urge to improve 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?

Borrow less than you can afford:

In India, lenders typically allow you to take on EMIs (equated monthly instalments) of up to 50% of your disposable monthly income after deducting your fixed outgo. For example, if Madhu earns ₹1 lakh a month in take-home pay and already pays EMIs of ₹10,000 a month on a car loan, the lender will allow her to take on an additional EMI of slightly less than ₹40,000 a month. If she’s seeking a 15-year home loan at 9%, this translates into an eligibility of about ₹40 lakh.

But remember, lenders have a business interest in stretching your loan eligibility. When you take on EMIs that eat up 50% of 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 the ups and downs in your income or career.

Therefore, it is better for you to 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% from your income, to arrive at an EMI that you can comfortably manage.

Borrow to invest in appreciating assets

For leverage to make financial sense, the return you earn on the leveraged asset should be higher than your borrowing costs. Given the high interest rates for retail borrowers in India, it is often very hard to find assets that can earn you a higher return than the interest rate you’re paying on the loan.

However, 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. Vehicles, double-door fridges, smartphones or home theatre systems are depreciating assets that lose value the moment you buy them.

Borrowing to fund consumption or experiences like 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 and invested enough towards the goal.

Don’t bet on big increments

We Indians are used to high income increases from year to year. When taking on loans, this makes it tempting to stretch ourselves to sign up for higher EMIs than we can afford, as we believe income growth will reduce the burden over time.

The calculation made sense when inflation was running at 7-8% and annual increments at 10-12% ; both are no longer true. With salary increases across many sectors moderating to the 5-6% range, don’t expect the burden of a large EMI to reduce materially over time. With variable compensation leading to fewer guarantees about your future pay and pink slips becoming more prevalent in India, there’s all the more reason 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 size of the total liability. One way in which lenders often make EMIs more ‘affordable’ for you is by tempting you with 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% 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 (including principal and interest) at the end of 15 years. Stretch the tenure to 20 years, and while your EMI falls to ₹44,986 the total amount you end up repaying the lender is ₹1.07 crore. With a 20-year loan, you’ve ended up paying the lender an interest of ₹57.9 lakh, compared with ₹41.2 lakh in the 15-year loan.

This is also a good argument to always negotiate with your lender to increase your EMIs (and not tenure) when interest rates rise, and to prepay your loan as soon as you can.

Shop for better rates

Once we’ve taken on EMIs, we often put the loan on autopilot, paying up the monthly EMI without ever 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 — be it the base rate, MCLR or the RBI’s repo rate.

Often, lenders woo new borrowers with their best rates while older loan-takers 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.