How much debt do you have? How do you answer this question? A) Rs 50 lacs for 15 years OR B) EMI of Rs 47,782 per month for 15 years?
Both have the same meaning. If you track your loan amount properly, you will answer in terms of the outstanding principal amount. However, when it comes to affordability, managing your cashflows and mental accounting, you will likely think of your loan in terms of an EMI.
I read an interesting article on EMIs in MoneyLife, While I agree with the author on many points about EMIs, the article seemed to give an impression that EMIs are bad. That’s where I beg to differ with the author.
Why Are EMIs Bad?
As a borrower, you entail an additional cost of interest, especially during the initial years of your loan tenure when a big portion of your monthly installment goes towards interest payment and very little goes towards principal repayment. In one of the posts on Rent vs. Buy, we called interest as Rent of money borrowed. And the costs are never good.
More importantly, access to easy credit may push up your tendency to overspend. You may undertake expenses that you wouldn’t normally take in the absence of access to credit. For instance, you can buy a Rs 20,000 phone by paying upfront. Or you can buy an Rs 50,000 phone by paying Rs 4,500 per month for 12 months. You choose the latter option. I am no one to suggest what kind of phone you must buy. However, if both the phones meet your configuration and lifestyle requirements and you do not have unlimited resources, is it wise to buy an expensive phone just because you have easy credit available?
And this irresponsible spending behaviour can be a problem. The EMIs may be comfortable today. However, in case of job loss or salary cut, the EMIs may cease to be comfortable. Or if you are forced to take a loan (say in case of a medical emergency), the total EMI may breach your comfortable zone. If such shocks are not handled well, you can get into a debt trap.
Are All EMIs Bad? Is All Debt Bad?
In my opinion, borrowing is not a problem per se. Yes, irresponsible credit behaviour and frivolous spending can be land you in trouble, but you cannot term all EMIs bad. In fact, access to credit can be extremely useful. To a responsible borrower, loans are a good way to gradually accumulate assets and get to your desired standard of living.
Buying a house by paying Rs 50 lacs upfront looks a gargantuan task for many of us. However, taking ownership of that house by paying Rs 47,000 per month for the next 20 years does not sound as difficult and seems within reach. An own house may give a sense of financial and emotional security to the family. How do you account for this in a spreadsheet?
You may not have Rs 5 lacs with you to buy a car. Rs 10,500 per month for 5 years seems possible.
Ask any corporate finance person. Debt is a good way to fund massive projects (assets), provided those assets turn out to be productive and repay debt through cashflows generated. The same debt becomes a problem if the asset can’t repay debt. This is because the debt must be repaid, irrespective of whether the asset yields sufficient cashflows. Therefore, while taking on more debt enhances return on equity (and should be considered favourable for shareholders), higher leverage also means higher risk.
Individuals are not too different. Responsible borrowing can be helpful. Too much debt can harm both individuals and companies.
Is Saving up an Option?
A common refrain is that you should save up instead of going for a loan. For instance, instead of going for a loan, you save for a few years and use the money. Makes sense. It is OK if you buy a house at the age of 50 rather than at the age of 40. However, can you do this for everything? Can the higher education of your kids wait for 3 years? Would you pursue a degree or certification to enhance your career prospects now or after 2 years? You need a car to commute your elderly parents to hospital every week? Would you save up for 2 years or buy a car on loan? Many have not been seeking services of domestic help since the pandemic began. Is it a bad idea to buy a dishwasher on a No-cost EMI (provided you can afford it)? Hence, saving up may not be always be option. You may have to go for a loan.
Practice Responsible Borrowing
In my opinion, there is nothing wrong with EMIs per se. The problem lies in borrowing (and spending) irresponsibly and not planning for exigencies in life. Here is what you need to do.
- Do not over-borrow. Do not borrow just because you can. Limit your borrowing as a percentage of your net monthly income. It is difficult to pinpoint an exact percentage but 35-40% of net take-home pay is a reasonable upper threshold if you are servicing a home loan EMI. Without a home loan EMI, this number should be much lower.
- Remember, after providing for EMIs, you just don’t have to fund monthly expenses but also invest for your future.
- Take loans only for building assets (home loan), value additive activities (education loan) or necessities (car purchase as in example discussed earlier). Please understand this is not an exhaustive list.
- Avoid loans for lifestyle expenses (expensive gadgets or vacations). It is in such cases where thinking of loans in terms of EMIs can be a bad idea. In most such cases, better to save up and then spend.
- Don’t trust your luck too much. Things will go wrong. Be prepared. Build a robust emergency fund. In case of pay cuts or job loss, this will come in handy.