Debt is not evil. In fact, if used responsibly, debt can be extremely useful.
Yes, taking on debt involves additional cost in the form of interest. Clearly not desirable but that’s just the cost of capital. If you are using your own funds for purchase, consider the possibility that those funds could have been invested elsewhere to earn superior returns. Don’t ignore that you also get to enjoy the purchase or ownership much sooner if you decide to take on debt.
How do you weigh the joy/comfort of an experience, or an asset purchased using debt against the interest cost?
Let’s consider the example of a house purchase. You want to purchase a house worth Rs 50 lacs. You have 2 options.
- You first accumulate Rs 50 lacs and then buy a house OR
- You take a home loan of Rs 50 lacs. Pay EMI 64K per month for 10 years (9% p.a., 10-year loan)
Under (2), you will pay Rs 76 lacs over the loan tenure to close the loan. Total additional cost of Rs 26 lacs in the form of interest.
Well, you could have waited for a few years and accumulated those Rs 50 lacs and then purchased the house without any interest cost. However, there are a few points worth noting.
- Under (2), you are not paying the entire interest upfront. You pay this interest over the course of 10 years. Good time to refresh the concept of time value of money.
- You get to stay in your house much earlier under (2). To most Indian families, house ownership adds immensely to their sense of social, emotional, and financial security.
- You may also save on rent.
- The value of the house may rise in the interim and you may have to pay more to buy a similar house using own funds.
There are no right or wrong answers here. Buying using your own funds or taking a mortgage is a personal preference. Hence, if you are planning to buy a house, I leave this decision to your judgement.
However, interest cost is not the only problem with debt. A far bigger problem is you may develop a tendency to overspend. Credit gives you power to spend money you don’t yet own. If you are spending your own bank account, you can’t spend more than the money you have in your bank account. With credit, there is no such restriction and that can land you in trouble. If you borrow more than you can easily repay, the financial stress will eventually show up.
More debt → Bigger EMIs → Greater pressure on cash flows and more debt to bridge cashflow gap
And this can become self-perpetuating. As you accumulate more debt, the cost of borrowing may also inch up, putting even more stress. If this chain is not broken soon, you get into a debt spiral. As they say, too much of anything is bad. And that brings us to the titular question.
How to Avoid Taking Too Much Debt?
You get into debt problems when you borrow way beyond your means. In this section, we look at ways that will nudge you towards borrowing less.
#1 Earn More
Most of us borrow when we don’t have the money to purchase outright. Earning more could be a solution. I understand this is not always easy and not completely under your control. However, if you are struggling with cash flows, perhaps you are just not earning enough. Hence, keep climbing the ladder in your career. A job loss can also upset your finances. Hence, it is important that you keep enhancing your skills and keep yourself relevant.
#2 Spend Responsibly
You can always find avenues to spend more but you must draw a line. No one has infinite resources. And if you spend more than you earn, you will have to borrow to bridge the deficit. Hence, be responsible with your expenses.
Sometimes, we end up spending more simply because we don’t realize we are spending more. Had we known, we could have controlled expenses. Just that awareness can go a long way. Budgeting will help here.
#3 Borrow Responsibly
All debt must be repaid.
Before borrowing, consider what you are borrowing for and how much you should borrow.
It is easier to justify borrowing for creating assets, e.g., purchase of a house. Contrast this with taking a loan to buy an expensive mobile phone. Again, no right or wrong answers here. You are the best judge.
Additionally, look at the quantum of loan. You can calculate the EMI before you take the loan. If you sense that the EMI will stretch your cash flows, reconsider your purchase decision or its timing.
#4 Financial Planning
Plan for your expenses. If you have already been saving for the purchase or an expense, you may not need to borrow for the same or you may have to borrow less.
For instance, if you have been diligently investing for your children’s education, you (or your kids) may not have to borrow to fund their education. This approach can also be extended to smaller expenses too. You want to buy a phone worth Rs 50K. Just invest Rs 8K per month in a recurring deposit for 6 months.
Further, financial planning also gives you a reality check. When you calculate the monthly investment required to achieve your financial goals, you get to know where you stand. When you know that you have not been investing enough for your goals, you will automatically try to control your expenses.
If you look at this in another way, financial planning can help you be responsible with both your expenses and borrowings.
#5 Build up a Contingency and Unplanned Expenses Fund
Everything was going fine until an unforeseen expense hit you. That expense could be towards medical treatment/procedure or an unexpected expense (loss in business/car damage/house repair). Alternatively, it could be loss of income due to job loss and disability.
You can’t plan for everything. That’s why you must build a robust buffer to take care of such expenses. With such a corpus, your ability to handle such events will go up notches and the need to borrow will automatically go down.
#6 Buy Insurance
Buy adequate health, life, and disability insurance.
Expensive healthcare procedures can upset your finances. It is not uncommon to see surgery costs pushing people under loads of debt. A robust health insurance cover can provide protection against the financial impact of expensive treatment.
Similarly, a disability cover can provide coverage against loss of income due to disability (temporary or permanent).
While term insurance may not come into play until you are alive, it is critical that you purchase adequate term life insurance too. Will help your family settle any debt and get complete ownership of assets when you are not around.
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