06 December, 2010

Watch out before you cash in on your future income

Holidays and LCDs on EMIs and many other goodies on credit cards and a home bought with a huge dollop of loan, are all commonplace now. No one really worries about such things any longer. Being in debt is almost fashionable today. Also, in most cases, it is not possible to avoid it – like in the case of buying a home. Most people today want to buy a home early in their lives... that means, they may not have too much money to pay upfront and a bulk of it will have to come from a loan.

Everything done in right quantities is good. Brandy and wine, they say, have medicinal benefits, if had in the right quantities. But many people stretch the definition of “right quantity” and end up getting sozzled... and that is where the problem lies. Loans may be needed in certain situations. But, they need to be managed properly so that they don’t get the better of you.

When you take debt, you are essentially cashing in on future income. So, one needs to clearly weigh whether it is a good idea to draw on the future income. The most important thing then before assuming debt is to be clear about the pressing need for the object/service and the conviction that assuming debt is the best or the only option.

Today, loans are available quite easily. Hence, the temptation to just go around, get a loan and get your favourite toy or indulgence, is irresistible. That is why one needs to be careful. In the need to keep up with the Kapoors and Sharmas, one should not get sucked into the vortex of debt.

Again, there are benign loans like home loans, where an asset is created... there are others which can be worrisome – like credit card debt, personal loans etc. Going for a refrigerator on a loan may be justifiable – for it has become a necessity today. But assuming a loan for acquiring a huge LCD TV or a holiday abroad, falls under the “worrisome” category.

Easy serviceability of the loan is an important parameter. It is important to ensure that the EMIs can be paid without problems, from your income. Generally, around 40% of the net salary towards home loan servicing would be fine. For double income families, the portion of the income towards servicing home loans can go higher, as only a small fraction of their joint income may be needed for normal household expenses. However, in such cases, there will be a compulsion for both to work for extended periods of time and any break in one person’s earnings, can prove to be disastrous.

Other loans can be taken, based on cashflows. However, it is a better idea to start saving for it and then buying it. For instance, it is a good idea to save `3,000 per month for a year and then buy an LCD TV, instead of going for it with a loan. The end result is the same. But, in the second case, it is a more self-reliant and disciplined way of enjoying life.

If debt taken together is over 60% of one’s income, then it is a danger zone. Most look around for the cheapest debt. But the question to ask is, do I need to assume this debt. Anything done within limits, is good. Beyond limits, it becomes poison.

Published in The Economic Times, 7/10/2010

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