There’s plenty of personal finance advice on saving and investing wisely. But for most young folks, borrowing to fund their lifestyle often precedes investing.

Biting off more loans than you can chew early in life can put a spoke in your wealth creation plans even before you get started. With many lenders jostling for the retail loan pie, loan products today come in slick disguises too. So here are some tips to avoid the pitfalls and borrow wisely.

Borrowing for a good purpose

Any kind of borrowing entails taking on future hardship in the form of loan obligations to gratify an immediate need. But getting into the habit of instant gratification for all your needs, wants and luxuries locks up your future incomes in EMIs and robs you of the flexibility to make career or life decisions.

This makes it important for you to put some thought into the kind of spending for which you will borrow. To ensure that loans don’t deplete your wealth, distinguish between appreciating assets and depreciating ones.

When you borrow to invest in an appreciating asset such as land, a home, or an educational degree, returns you earn in the long run can compensate, at least partly, for the interest costs you incur.

But if you borrow to fund depreciating assets, you face the double whammy of interest costs on top of eroding asset value. Folks who take loans to replace their smartphone every year would know the pain of paying EMIs, long after an item has outlived its usefulness.

Don’t step-up EMIs

When assessing if they can afford a new car, consumer appliance, or home loan, most folks look at only the EMI or equated monthly installment. Knowing this, lenders obligingly structure their EMIs ‘flexibly’ as step-up or balloon EMIs, so that the initial EMIs are small, but expand as time goes by.

But this gimmick hurts more than helps you as a borrower. Lower EMIs at the beginning of your loan term merely postpone your repayment and help the lender load extract additional interest, adding to your total outgo.

Take the case of a ₹10 lakh car loan for 5 years, at a fixed rate of 7.5 per cent. The EMI based on the old-fashioned fixed calculation would be ₹20,038 per month. This essentially means a total outgo of ₹12.02 lakh including interest on the ₹10 lakh loan at the end of 5 years.

Should you opt for a step-up EMI, where you pay ₹8,990 for the first six months and ₹22,240 for the next 54 months, you end up shelling out ₹12.55 lakh for the same term. In a balloon repayment scheme, which stretches your loan tenure to 7 years, you start with an EMI of ₹11,110 in the first year, going up to ₹12,220 in the second year, and so on until your EMI hits ₹99,990 in the last month. In this case, you’d end up shelling out ₹14.12 lakh to the lender. That’s 17 per cent more than the simple EMI.

Shop around for better rates

When it comes to investment products, most folks are constantly on the hunt for better rates. But with loans, they carry a misplaced sense of loyalty to their lender and pay EMIs like clockwork.

Worries about processing charges and paperwork are also deterrents to making any switch.

However, Indian lenders are no longer allowed to charge prepayment penalty on floating rate loans.

Most lenders are quite willing to offer attractive deals with minimal paperwork to customers jumping ship from their competitors because they like to add new clients with a readymade repayment record.

Your existing lender may take his own sweet time to reset your interest rate when market interest rates are falling.

But most lenders are quite willing to offer much lower rates to their brand-new customers. This makes transferring your home loan balance to a new lender the best way to expedite rate resets.

Given the size and tenor of home loans, a simple switch from one lender to another can make quite a difference to your wealth in the long run. Switching a ₹30 lakh home loan with a remaining tenure of 15 years, from a bank charging 8 per cent interest to one charging 6.75 per cent, can reduce your EMI outgo from ₹28,670 a month to ₹26,547 and your total loan repayment from ₹51.6 lakh to ₹47.7 lakh.

Prepay at every opportunity

Loans, as we explained earlier, can rob you not just of the ability to spend, but also of career and financial flexibility. This makes it important for you to pay down your loan whenever you accumulate a reasonable lump sum.

If you’ve built up significant sums in your bank deposits from salary cheques, bonus from your employer, or a windfall from the stock market, use that to prepay your loans as soon as you can.

While prepaying, prioritize high-rate loans and keep tax benefits in mind. But ultimately, if you have sufficient sums saved up to prepay your home loan, don’t let tax considerations nudge you into continuing with EMIs.

The tax saving on a home loan repayment only lets you save on your interest costs and doesn’t really bolster your income or wealth.

This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online. )

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