Ten things you must assess before going for a loan

Amit Kukreja“Debt is the most successfully marketed product in the history of the United States” says Dave Ramsey, who is a personal money-management expert, famous financial author and a radio-host in the United States. Visa and Mastercard have existed as strong brand names for almost forty years now; needless to say they are a reflection of borrowed spending behavior of their customers. People view “debt” as normal these days. Some people even consider debt as a tool to create prosperity. Given the younger population in India (i.e. many more years of work life still at hand), many Indians resort to debts to bridge the gap between their reality and aspirations. Smooth disbursal processes, low lending rates and easy pay-back schedules ease the entire borrowing phenomenon for an individual. However, here is a checklist before you borrow further. Do your homework before you sign the dotted line.1.Can you afford it? Have you reviewed the repayment schedule of the new loan that you are planning to take? Does the EMI fit well in your annual expense cash-flow? One must have a look at the loan period and the impact of its EMI in his/her annual cash-flow for the years until the loan is paid-off.2.Why are you borrowing? Do you know why you are borrowing this money? Is it for the convenience of paying back the money in installments? Or is it because you don’t have money to purchase the product by yourself? Whatever be the case, one must understand the impact of interest cost that he/she would be paying for the loan for the loan term. The convenience of EMI increases the cost of the product that is being bought with the new loan.3.Have you understood the cost of borrowing? You must take a stock of processing fee, annual charges if any, foreclosure charges, re-financing cost, and competitive rates by other lending institutions. One must assess the money that is being paid to the lender for the loan product by the borrower.4.Have you examined the exit clause in the loan agreement? What’s borrower’s exit clause from her loan agreement? Are you forced to pay the EMIs for the contracted term or do you have the flexibility to pre-pay the loan and exit agreement without hurting your credit history? Some lending institutions would want you to pay the interest for a longer term and may hinder your exit earlier than the pre-defined tenure. Evaluate your exit.5.Have you assessed your debt-service ratio & Net-worth? In pure financial planning terms, percentage of earnings that is being spent towards loan repayments via EMIs determines one’s debt-service ratio. One must ensure that the total EMI being paid in a month does not exceed 45% of the total take-home salary. If it does, one must assess the impact of having higher debt-service ratio. If loans are taken for homes as a financial leverage tool, then wealth-creation graph and the role of the new loan would play in your wealth creation strategy must be thoroughly assessed.6.Who will take care of the loan if you are not around? If you are a borrower, you must visualize a scenario that who will pay for the loan if you are not around? Are you adequately insured? Is the process of opening and maintaining your loan also taking care of insuring the outstanding principal with the lending institution?7.Have you understood the advantage of having a clean credit history? Remember that having no-defaults in paying back the borrowed money is of utmost importance. Be sure that there would never be any default in paying the EMI as that may hurt your credit records with the credit bureau. Be clear about your commitment to pay-back the money regularly for the entire loan term.8.Is this a loan for a product that appreciates or depreciates with time? Do you know that there are certain loans that are good from taxation perspective? Do you know that if you are borrowing at x% for a product and the product is appreciating at the rate of (x+y)% then you are making y% gain on your borrowed money. Home loans were one such example. The interest payment is exempted under tax laws and if the real estate sector is doing well, i.e. giving returns better than your home loan rate of interest, then your loan is creating financial leverage for you. Another example is education loan where a child builds his/her earning capacity by building academic qualifications. One must understand that depreciating assets can cost you dear if purchased with a loan but appreciating assets can multiply your spent or invested money.9.Evaluate the good-part of having a loan. Loans help build your credit history with credit bureau. That makes it easy to borrow money in future. Some loans help you from depleting your retirement corpus and thus protect your retirement portfolio or any other goal that you would not like to be impacted at all. Some loans, like education loans, can even help your children to develop discipline in money management and financial quotient. Assess the tangibles vis-à-vis intangibles.10.Have you realized the importance of being debt-free? Have you determined the age by when you would like to be a debt-free person? Do you believe that in your life, a time will come when you would want to be free from loans completely? One must assess if taking a new loan is falling in the process to achieve the debt-free stage or pushing out this goal further in future.Amit is a member of The Financial Planners’ Guild , India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.