IT IS common knowledge that any borrowing may result in a debt trap. But this is not always true. A loan which leads to the creation of an asset is not bad, provided the quantum of loan should be within the repaying capacity of the person. However, a person should first develop an understanding to separate good loans from bad ones.
Home Loan: Home is a revenue-generating asset which appreciates over a period of time. Home loans are generally available at a low rate of interest and come with tax advantages while the loan is being repaid. It is a high value and long tenure proposition. However, the spectre of voluminous loan amount as well as long period of repayment induces a tendency to prepay the home loan when a person receives lump sum money. This is not always a good idea. Firstly, the interest portion on a long tenure loan in the initial few years is very large compared to the principal repayment. Secondly, as the years pass by, the inflation may actually erode some value from the EMI being paid. Thus, an amount of 10,000 paid as EMI after five years at a running inflation rate of 6% will be worth only 7,472. Meanwhile, the income level may also rise, making the EMI a smaller portion of total income. Moreover, a possible penalty on pre-payment and the partial forgoing of tax benefits may make the pre-payment all the more unattractive. Instead, the lump sum money received can be employed in some good investment vehicle to generate long-term wealth.
Auto Loan: The automobile can depreciate faster than the outstanding loan amount. An automobile is also an asset (though it does not generate income and depreciates in value unlike property). Looking at this, the tenure of the loan should be short, say 3-5 years. The unusually high processing charges should be avoided as they add to the overall cost of finance. The pre-payment penalty clause should be negotiated to avoid unnecessary charges if the loan is foreclosed.
Personal Loan: You should go for a personal loan only if there is a crisis, as the rate of interest is more than 15% in addition to the processing fees. The rate of interest can be negotiated further by offering collateral and furnishing details of credit strength, income flows, etc. Avoid using such loan for personal consumption like buying durables, or going on a vacation. In contrast to personal loans, there are other cheaper loans available, e.g. loan against securities, gold and property, which can be effectively used. You can avail of such loans against a collateral at rates that are 5-15% lower than those charged by personal loans. The repayment tenure is also longer than a personal loan.
Credit Card: Credit cards should be used as convenience tools in lieu of cash but should not be sought to enlarge cash availability beyond your means. They are an effective financing tool during a narrow phase when cash is expected. By efficient use, one can make use of reward points and other attendant benefits. One should make use of the free credit period and repay the credit before the scheduled due date.
A person must carefully understand the instances in which s/he may end up paying huge interest and other charges. The interest charges applicable in case of rollovers and part payments are more than 33% p.a. The minimum outstanding clearance is a sure method of falling in a debt trap, as the full interest is charged on all fresh purchases from the very date of transaction. The parameters such as credit limit and due date of payment should be adhered to as there are over-limit and late payment charges, too. You should avoid using credit cards to finance charges on white goods, travel and other consumption to fully repay the amounts incurred on the due date.
