Loan is not just a four letter word. Sometimes it is necessary, and sometimes it is good. So how do you figure out if loan is good or bad? How much of it is good? And when you should repay it back?
Like any other answer, it depends on lot on your personal situation. You need to answer questions like
- What are you taking Loan for? Is it appreciating asset or depreciating asset? Is there tax advantage with debt?
- What is the interest rate on the Loan? What is the payback amount and time you are comfortable with?
- How much can you pay from your savings and investments? Is it better to liquidate your savings and reduce Loan?
Lets look at these questions in more detail
Purpose of Loan
Typically Loan taken for something that appreciates over time is good. Good examples are buying a house or funding for your education. There is good probability that the value of your house will not decline, more so you will also avoid paying rent once you move into your house. Education helps you move ahead in your career. Another important factor in favor of taking housing loan or education loan is tax saving these loans provide as exceptions.
On the other hand taking loan for car or loan for consumer durable is very expensive – they cost you not just in terms of higher interest rate, but the products depreciate over time. So for the product you paid Rs 100, is not worth Rs 70. But you are paying interest on Rs 100 borrowed earlier.
Interest rate will determine the amount of money you need to pay back and, assuming you are paying back through EMIs, the duration you will have to keep paying back. Rule of thumb is that the total EMI outgo per month should not be more than 40% of monthly income. But actual number depends on your total monthly income. In addition, you should not be paying very high interest rate.
Sometimes it is better to utilize your savings instead of taking loan. If interested rate on loan is higher than the returns you are getting on your savings, it is better to use savings instead of taking loan. However make sure you dont use your personal emergency fund – it is not advisable to substitute loan by using your emergency savings. It is important to keep some liquid money for emergency. Third important criteria is to consider taxes – check if liquidating your savings or investments will cost you tax in any way. For example selling ELSS before lockin of 3 years will make it out of tax exemption. Similarly short term capital gains on equity (1 year) or debt funds ( 3 years).
What are other important factors you should consider before taking a loan?