Good Loans & Bad Loans

I woke up this Saturday morning and it was wet and windy outside. What a waste of a weekend ! But suddenly I had a bright idea to work against the wind and rain – drove up to a near by shopping mall which claims itself to be the largest covered shopping complex in Europe. Adranalin on its maximum levels, sleep all gone – after all I am on a trip which I enjoy the most – window shopping of electronic gadgets 🙂 and the consequences, which I mostly want to avoid and mostly unable to avoid.. I ended up buying an expensive pair of Bose headphones… Both happy and sad.. Happy because now I own state of the art, pure quality as quality can be, best brand of music industry is now in my living room. Sad, because it set me back by a good Rs. 20,000. Is it a wise choice, definitely yes (my ears say) and definitely NO (my mind and wallet says). No problem, I bought it on my credit card and I have time to pay it back in one month. By the time I paid back the credit card dues on my newest purchase, I was shocked to see that a new model replaced my so called state of the art purchase and the model which I was previously proud to own is now worth 20% less in just less than a month !! Now even my ears don’t like the idea of me taking a loan to purchase something which has depreciated so quickly.

 

Lets take another example of my wiser side (I some times have one). I had Rs. 4 lacs in my bank account. A generous bank gave me a loan of 36 lacs (@10 % interest) and I purchased a house for Rs. 40 lacs. Within a year, the price of the property increased by 30%. Though my wallet was still not happy considering I had leveraged my financial status by 10 times of my ability to buy a property, however my mind said that it was an excellent investment option. By the end of 10 years my financial position with this transaction was something like this :

My contribution : Rs. 4 lac

Bank loan : Rs. 36 lacs

Bank interest paid over 10 years : Rs. 21 lacs

Total bank repayment : Rs. 57 lacs

Property value after 10 years : Rs. 104 lacs (assuming 10% return year on year).

So my initial investment was just Rs. 4 lacs which became Rs. 104 lacs in 10 years. Obviously I was also paying my monthly home loan (mortgage) payments, but still, I made a handsome Rs. 64 lacs over my initial investment. Howzatt ??

 

Leveraging

You may have read in physics – Levers. They enable you to lift heavy load by putting a fraction of the weight / effort. You may also be wondering that what does that Lever to do in Finance ? Loans act as financial levers to allow you buy more than what you have currently in your bank account. Let us understand it a bit more in detail.

Loans allow a person to own, purchase or procure more assets (whether depreciating or appreciating) than what he can currently afford. Banks are try to distribute loans to worthy people – hence there is no dearth of money if you can prove that you are deserving  enough (sarcasm intended – you need to prove that you really don’t need loan in order to make the banker believe that you are worthy of taking a loan). Once you have the loan, you are the owner of asset. Your own contribution in the asset is intially just the principal amount which you have contributed. Rest is owned by the bank. Over the duration of loan payment, you slowly own the complete asset. In return of the loan, you pay the bank an interest.

If the rate of growth in your asset is more than the interest rate payout, then you have taken a good leveraging decision.

 

Example of Good Leveraging

You want to start a business which requires Rs. 5,000 as initial investment. You contribute Rs. 1,000 and for the remaining Rs. 4,000 you take a loan from the bank at 10% interest rate. Your business earns 15% on the investment. At the end of the year the position would be :

Total investment in the business : Rs. 5000

Total earning from the business : 15% of Rs. 5,000 = Rs. 750

Total interest paid to the bank : 10% of Rs. 4,000 = Rs. 400.

Remaining earning after interest payout : Rs. 350 (750-400)

Return made on Rs. 1000 investment : 350/1000*100 =  35% – Excellent example of how leverage can help in making more out of the money which you have.

 

Example of Bad Leveraging

On the contrary, lets take an example of where leveraging can go horribly wrong. In the above example, lets assume that the amounts stay exactly the same, but your business earns 7.5% instead of 15% targetted rate. Your finances after 1 year would be :

Total investment in the business : Rs. 5000

Total earning from the business : 7.5 % of Rs. 5,000 = Rs. 375

Total interest paid to the bank : 10% of Rs. 4,000 = Rs. 400.

Remaining earning after interest payout : Rs. -25 (375 -400)

Return made by you on your Rs. 1000 investment : -25 /1000*100 =  -2.5 %.

In summary – leveraging is good only if the earning potential of your asset / business is more than the interest rate you are paying out for it. Else, it can take a horrible U-turn and sting at your bottom line !

 

Bad Loans and Worse Loans

Irrespective of what are the positive side of loans, I still can’t justify that loans are good. They can either be bad or worse. The rationale behind it is that loans are an excellent way to help the banks and the selfish businessmen to sell unaffordable consumer items to people and let them stretch their financial bedsheet much beyond their means. As long they are stretched upto a limit whereby the borrower can service the loan payments, its harmful affects are not very obvious (though your monthly cashflows get denominated by loan payments). Beyond that limit, the borrower tends to default on the loan payments and thats where the horrible effects of loan start taking shape. Let me enumerate a few :

1.  If you forget paying your loan installments by mistake – you get your credit history screwed up, which tremendously reduces your ability to take loans for transactions which genuinly require help from a loan (such as a home). Read more about it at Improve your Credit History – Timeline of Your Current & Future Financial Image.
2. If you are unable to make your loan payments, then you get hit by penalty charges and higher interest rates. I have seen so so many examples whereby people are paying over 30% interest rate on loans which they can not service timely ! And then your ability to make such payments reduces with every passing month.
3. Loan Recovery Agents are behind you (physically and emotionally) and they would make your life hell till the time you don’t make your payments. And they are not as polite as their title sound – they can be big time gundas who would take every possible step to extract (actually extort) money from you.
4. Repossession is the next step. The asset which you so proudly purchased may be repossessed by the financing bank. Imagine you getting back to square zero and taking a bus to go to office, as your car has been taken away by the bank.
5. Bankcrupcy – wow wow ! This is something which you should make sure that it never happens to you. It is a financial death of a person. If you are in the job sector (specially in financial services), if you apply for any visa, any official documents, etc, there is always a question ‘Have you every been declared bankcrupt ?‘. If the answer to this question is ‘Yes’ – then consider that your application is already rejected even before submission.

 

Some Tips Around Loans

Though loans come with many postives / negatives, there are some financial tips which may help you to reduce the pinch of loan installments. A few of them are enumerated below. If the readers have more in mind, please free to add them as comments to the article :

1. Tax deductions – This is first sop which you get – tax rebates. What does government get to give such rebates ? Well, if you take a loan and buy some products, you are boosting the demand in the economy which is one of the key foundation to keep the Economy afloat. If you stop buying, then the companies can not sell, which would result in shutting down of business, unemployment, lesser tax collections and so on.. Some of the tax sops are, reduction of housing loan interest from your income, reduction of business loans interests from the taxable profits. Students can claim interest on their education loans against their incomes in many countries.

2. Asset Liability Match (ALM) – Try to match the loan repayment duration with the asset’s function. For example, finance long term assets with long term loans. Financing a long term requirement with a short term loan would land you in higher interest payouts and possible cash crunch due to inability to fetch finances in line with the cashflows of your assets. The biggest example of ALM going very horribly wrong is the Credit Crises whose implications are being borne by the entire world for past couple of years and not sure for how many more years to come.

3. Reduce Interest Payout – Keep on top of deals available in the financial market. For example, if you are paying interest on your home loan at 12% and you can reduce it to 10% by switching your loan to a different bank, it would make a great saving on your interest payouts. On a loan of Rs. 20 lacs, it would mean over Rs. 3,000 per month difference.

4. Wasting Assets – If you can avoid, always avoid taking loans to finance your requirements for buying wasting assets such as consumer durables, holiday trips, etc. These items don’t add to your financial strength but on the contrary add as a drag on your financial health. If you top it up with the interest payouts, it further drags your financial health. Generally people give it to deals which require a small amount of extra money to pay over the duration of the repayment in order to own the asset now. However, if you do a quick maths, it would shock you. I saw a recent deal in one of the showrooms – buy a LED TV of Rs. 50,000. Pay just 5000 now and pay the remaining price in 10 installments of just Rs. 5000. The initial reaction would be WOW !! a LED TV for just 5K and monthly payment of 5K for 10 months – can’t be better than that. But lets see the maths behind it. You are actually paying 55K intead of 50K and it works out to be around 25% Interest rate over 10 months !! I hope you can appreciate the financial mess people put themselves into by accepting such deals. Combine it with the fact that after the end of 10 months, your TV shall be worth less than 30K.

 

Conclusion

Irrespective of what I mentioned in this article, some loans are really important and add value to life. The top two loans of this category are :

1. Housing Loan – Very few have the financial appetite to buy the entire house / flat in one go. Even the richest of the lot may not have that much liquidity to allow them to buy the property in one cheque payout. Housing loan bridge that much required gap and lets you own a property. However, you may also want to read my article Your House – A drain on your Finances which gives another financial perspective in the house purchase decision.

2. Education Loan – Education is one of the best asset you can and the returns of investing in Education are multifold as well. A MBA degree from a good school may cost around 10 lac. However, after completing your degree, your first job shall probably land you in about 10-15 lacs annual package – Awesome return !! and this is just the start.

However, I still maintain – that no loan is good – they are can either be a Loan or Bad Loan.. What would be your take on it ?

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