Differentiate between ‘good loans’ and ‘not so good loans’
Where the net cost of borrowing is higher than the yield on investments, the loan is not good for you
I have outstanding loans of Rs42 lakh. Of these, Rs20 lakh is from relatives and there is no urgency to clear immediately. There is a Rs8.5 lakh home loan with an EMI of Rs13,000; home equity loan of Rs6.4 lakh with an EMI of Rs10,000; personal loan of Rs1 lakh with an EMI of Rs22,000 and two gold loans of Rs3 lakh each.
The major expense is Rs7 lakh for my sister’s medical education, due in 2016 and 2017. My rent and other expenses are Rs30,000 per month. I have just started a job that pays Rs60,000 in hand. My wife gets Rs20,000 in hand.
Apart from repaying the loans I want to buy term insurance for myself and my wife. If there is money to spare, a health insurance cover too. My corporate health plan covers my wife and parents and I’m more inclined to take one for my sister. My father has just landed a job after a short stint of unemployment, and is taking care of the home and home equity loans, but I’m not sure for how long. He is 50 years old.
The loans can broadly be divided into three categories. The equated-monthly instalment (EMI)-based loans: housing, house equity loans and personal loans, which are also of longer tenures. Gold loans: where only the interest is being paid now and principal is to be serviced at loan repayment; these are of shorter duration. And loans from family and friends: they don’t have any fixed time line for payment of principal or interest but they carry a risk of reputation so they should not be taken for granted.
Loans can typically be classified as ‘good’ loans and ‘not good’ loans. Simply put, loans that offer an interest rate lower than earnings rate—which is the rate of interest that your investments can earn on an appreciating asset—are classified as good loans. These loans, such as for housing and education, also offer tax arbitrage.
All other loans, where the net cost of borrowing is higher than the yield on investments, will be ‘not good’ loans, as this means that you have not been able to match your income and expenditure.
There must be valid reasons for so many of loans. However, except the housing loan, no other loan can be classified as a good loan. Prima facie it seems that most of the loans were taken to manage personal cash flows. One reason for this could be your father’s unemployment. Going forward, all expenses should be provided for with regular and disciplined savings.
First, determine your monthly surplus. Preferably, include all your incomes in a single pool. All EMIs need to be paid regularly. Check whether you can move into the home on which you have a loan. If not, check when you can move in, and save on rent. Invest any surplus you can generate, on a regular basis. To start with, invest in debt asset classes, such as bank fixed deposits and ultra-short-term and short-term debt mutual funds.
The money for your sister’s education is required in the near future. You may not be able to save the corpus in time. The best option would be to go for an education loan. This offers deduction under section 80E of the income tax Act, as well as a repayment holiday over the course period thereby, not putting too much burden on your cash flows.
About insurances, you should buy a term life insurance for yourself and your spouse; and buy a separate health plan for your sister. Do not increase your coverage now, as this will put additional pressures on your cash flow.
Surya Bhatia is managing partner, Asset Managers
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