When is it worth going into Debt ?
Written on Friday, May 27, 2016
By Team Bajaj Capital Ltd.
NEVER. As a fundamental principle of financial planning, all forms of debt should be avoided. Servicing debt means one is paying interest which is an out-flow. This adds to the cost over a period of time and in turn reduces the gains or profits derived out of the final transaction. Remember, all kind of debt is a liability thus reducing your net worth. It is equally important to see how much your investments earn and what you pay as interest on your debt. If your investments earn less than what you pay as interest, you aren’t doing a great job. Therefore, better to get rid of any debt and thereafter start investing.
Variants of Debt :-
In money-parlance, there are two major kinds of debt- Constructive and Un- constructive. Personal loans, credit card, car loan would fall under non-constructive loans. Such loans are for purpose of owning assets whose value over time depreciates. In case the value of asset increases over time such as real estate property, the loan is considered constructive.
Life and Debt:-
Easy form of debts such as credit card, personal loans are becoming a fad nowadays. Over dependance on debt for uplifting your life style by acquiring consumer goods or otherwise leads to a “debt trap” which if mismanaged becomes irreversible, so much so, that “debt trap” is literally equated with “death trap”. Banks resort to aggressive marketing practices and provides easier access to credit cards to Gen “X” who are falling prey to these lure of easy money. The interest charged on cards of around 36 percent per annum skyrockets the interest burden unless managed well.
The Debt Bubble:-
If debt is not paid when its due, the interest is charged on the unpaid amount. Together, it forms the outstanding amount i.e. interest plus the unpaid amount. If this cycle continues, outstanding amount balloons and soon the person finds himself in a debt trap. The original unpaid or the principal amount would have been a low figure but interest portion would become huge. At this stage, people resort to selling off their assets or breaking investments in order to repay the debt.
Those who are carrying debt, should properly plan to get rid of it as early as possible. Put a plan in place. Stop any further purchase on the card if its a credit card loan. Do not just pay the mandatory 5 percent of outstanding but instead, start prepaying as much as possible keeping household budget in mind. If there is personal or car loan, stick to paying EMI's. Prepay them if there are no prepayment penalties.
However, not all type of debt is bad. Leveraging one's income to acquire constructive asset is already accepted as a preferred mode. For example, a home loan taken to acquire a real estate property is considered as an appreciating asset unlike a car which is a depreciating asset. Home loan may thus help in creating a long term asset even after offsetting the interest paid.
Typically, keep your EMI commitments towards loans not more than 40 percent of your take-home income. Its a danger signal, the moment the limit is stretched. Keep debt at bay and enjoy the benefits of your savings efficiently.