First pay off high cost debt. Ensure investment fetches higher rate than loan rate
Traditionally Indians have been wary of taking loans. Even for starting a business or for business expansion plans, people used to rely on pooling savings from family members. Loan was considered as a burden and people used to take loan only in case of dire needs. Also, due to lack of access to formal financial sector, many of us would go to local money lenders who used to charge a very high interest rate on loans.
In the last couple of decades, the financial sector has spread its wings in the country. More and more people have come under the formal financial system and access to loans has become quite easy. With the recent financial inclusion drive by the Reserve Bank of India and the government, loans from banks and other financial institutions have become accessible to people even in remote villages in the country.
Changing attitude towards loans
While this is a boon for the economy and citizens, it has slowly started turning into a curse. Some people, especially youngsters, are tapping the credit market to meet even their day-to-day needs and to live a luxurious lifestyle. They are taking more than what they can repay. Access to credit cards has made the situation worse as it allows the card holder to spend the money today and pay at a later date. But people do not realize that they paying capacity depends on their earnings and savings and not on their expenditure.
It has become extremely important to manage loans in a systematic manner and plan its repayment accordingly to avoid falling into debt-traps.
Pay off high-interest debt
There are different types of loans, such as, housing loan, vehicle loan, business loan and personal loan. Even credit card balance is a type of loan as one has to repay it on time or the credit card company starts charging interest on the due amount. The first thing a borrower should do is to make a list of all loans and to prioritise loans they need to pay first.
The costliest loans are the ones that should be repaid the earliest. For example, the interest charged on credit card dues, if not paid within due date, is among the highest and ranges between 24 and 42%, and in some cases even higher. Credit card can be used as an asset if the cardholder pays the dues within due date as it does not carry any interest till due date. Also, the cardholder gets reward points and other offers on credit cards. However, if the dues are not cleared within due date, then credit card can become a huge liability due to very high interest rates. People should first try to clear all their credit card dues.
Interest on personal loans is also high compared to housing loan or vehicle loan. So, after clearing credit card dues, people should try to clear personal loans. Here one should remember that they should repay the costliest loans in such a manner that it does not impact the normal repayment schedule/Equated Monthly Instalment (EMI) of other loans. Defaulting on loan repayment schedule can have a negative impact on the credit score which can result in higher borrowing cost in future.
Investment v/s loan repayment
The spread of financial sector has not only provided access to credit facility but has also provided a formal investment structure. Investing in financial assets has become a norm. Everyone is trying to invest some part of their earnings in financial assets to meet their future goals. But at times, they find themselves in a fix on whether to go for investment or to first clear their loans.
Now this can be tricky. We know that loan is a liability as we have to pay interest on them. Also, the loan should be repaid on time and defaulting on loan repayment could have a negative financial and social impact. So, the first and the basic thing that should be kept in mind before going for any investment is that it should not hamper smooth repayment of loans as per the schedule or repayment cycle.
Secondly, the net impact of investment should be positive. That means the expected return on investment should be higher than the interest rate on loans. To be on the safe side, it should be at least 2-3% higher than the interest rate on loans.
WEIGH PROS AND CONS
- Make a list of all loans, prioritise them and pay off the costliest loans at the earliest
- Any investment should not hamper smooth repayment of loans and the net impact should be positive
- The expected return on investment should be at least 2-3% higher than the rate on the loan
The writer is founder, Fortune Securities. The views are personal and should not be taken as a basis for making investment decisions
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