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When is taking a loan a good idea?

The availability of credit is taken for granted in India today. Life was very different as recently as 10 years ago when getting loans for homes, cars, appliances, education etc. was much tougher.. We have fast become a very EMI driven consumption oriented society. Taking a loan is useful when it provide us with capital to allowing us to accelerate a purchasing decision, as long as we are confident and comfortable that we have the capacity to pay our EMI on time. On the flip side, taking a loan can be a disaster when we don't have the required income level to pay back our liabilities owed to the lender in a timely manner. In this latter scenario, it can hurt us in the long run and can affect our wealth.

What are loans worth taking?

1. Loans taken to create an asset
2. Loans taken to increase your human capital

1. Loans taken for consumption
2. Loans taken to buy assets that depreciate or become obsolete
3. Loans to purchase cars and appliances

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What are loans worth taking?

1. Loans taken to create an asset: As long as you are not speculating that the asset value will go up, it is worth taking a loan to build an asset. If you take a loan to buy a house, you are buying an asset that you expect will appreciate in value and over time might be worth more than the original price you bought it at. The loan allows you to build an asset, and the lender is comfortable lending to you because it takes the home as a security against the loan.
2. Loans taken to increase your human capital: If you take a loan that adds to your skills and improves your career prospects, you are giving yourself the opportunity to improve your earning capacity in the future. Such a loan is worth taking. For instance, if you take an education loan to say get a pilot's license or to get an MBA, chances are you are improving your job prospects and salary potential. Sometimes the lender might ask you to provide some kind of security towards the loan.

What loans are not worth taking?

1. Loans taken for consumption: If you take a personal loan to spend the money towards expenses such as buying clothes, taking a vacation or daily expenses, it could turn out to be disastrous if you know that you have no means of paying the loan back. At the end of these purchases, you have nothing to show for, apart from a liability towards your lender. There is no asset that you are building. People often take personal loans to fund their lifestyle that they could otherwise not afford on their salary without realizing that such loans are bad for their long-term financial health, because the could force one into a debt trap.
2. Loans taken to buy assets that depreciate or become obsolete: If you take a loan to buy the latest cell phone or LCD television, you are not creating an asset that goes up in value. On the contrary, the moment you unwrap your new purchase, it is no longer worth as much because now it is a used product. Secondly, over time newer models come out which further reduce the value of the product version that you bought. If you need to sell this item to pay back your loan, you will not get enough in the re-sale price to make up for the original loan amount you took. Again, if you have the capacity to pay the loan back in time, such loans can be worth taking, but we have seen numerous instances where many people borrow to keep up with the latest electronic accessory even though they could not afford it on their own salaries.
3. Loans to purchase cars and appliances: Like the above case, cars and appliances also depreciate quickly i.e., that the value of these items drops dramatically over time. Only take these loans if you are confident that you are not stretching your EMI paying capacity beyond your current comfort zone. We aren't arguing that taking a car loan is bad, but it can be when at the time of taking the loan itself you know that you don't have the means to pay it back.

Mental checklist before taking a loan?

• Understand whether the loan is for building an asset or to fund consumption
• Are you taking a loan to speculate on buying an asset? Recognize that if the asset does not go up, then you have the liability to pay the loan back in time and in full out of your own pocket
• Is the asset you are buying with the loan expected to appreciate in value (like a home) or will it depreciate in value (like a car)?
• Can you afford the EMI payments, in addition to the existing EMI commitments you might have? Your total EMI payments across all loans should not be more than 25%-30% of your take-home pay
• What is the term of the loan? Is it realistic for you to stretch the term out of the loan just to reduce the EMI payments?
• If you are unable to pay your EMI on time, what is the default penalty you will incur? What rights are you offering to the lender to either repossess the asset or take some other action against you?

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babubhi said : 21/12/2010	u hav may lon