Debt Decisions. Go easy on debt

From a financial planning perspective, the ideal answer as to when you should borrow is, ‘Never’. Debt is a liability and reduces your net worth. Servicing debt always entails an interest outflow. Therefore, even if you are using a loan to acquire an asset, this adds to its cost over a period of time and reduces the gains or profits you may derive out of selling it at a future date.

In this regard, before taking on any debt, it is important to evaluate how much your investments earn. If your investments earn less than what you will pay as interest, it would be better to pay down the debt before you start investing.

As an investor, you need to make a distinction between constructive and unconstructive loans. Personal loans, credit card and car loans are unconstructive.

They are being used to acquire goods whose value depreciates over time. Where the value of the asset acquired increases over time, such as in the case of land or property, the loan taken to acquire it is considered constructive. Over-dependence on debt for upgrading your lifestyle by acquiring consumer goods or otherwise leads to a debt trap, which, if mismanaged, becomes irreversible. The interest charged on cards, at around 36 per cent per annum, multiplies the burden of debt servicing on the investor.

If debt is not paid when it is due, the interest on the unpaid amount will snowball. If this cycle continues, the outstanding amount balloons and soon the person finds himself borrowing again to pay off older dues. As each new loan will come at a higher interest rate than the older one (given the loss of credit-worthiness), you may be forced to sell off your assets or prematurely redeem investments in order to repay the debt. That could result in a double-whammy on your net worth.

If you already have sizeable debt, you need to plan to reduce it as early as possible. If it is a credit card loan, stop any further purchases on the card. Do not just pay the mandatory 5 per cent of outstanding balances.

Instead, reduce your expenses to prepay as much as possible. If there is a personal or car loan, don’t just pay your EMIs, but also actively look to prepay them if you have surpluses.

Not all types of debt are bad. Leveraging one's income to acquire an appreciating asset can pay off over the long term. For example, a home loan taken to acquire a real estate property can be net worth positive if your property appreciates at a faster pace than the interest you shell out on your loan. A home loan may thus help in creating a long-term asset even after offsetting the interest paid on the loans you have taken.

Typically, keep all your EMI commitments contained at not more than 40 per cent of your take-home pay. The moment this limit is breached, it is a danger signal. Keep debt at bay and build your net worth.

The writer is Group CEO & Director, Bajaj Capital

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