Personal loans are easily available. Many banks even claim to provide instant personal loans. You get regular email alerts that you have a pre-approved loan. And if you are planning a very expensive vacation, don’t think twice because the personal loan is yours for the taking. The picture is rosy. Your ego is bloated. Cost is ignored. You take a loan. Well, a loan does not come without interest. Once you take a loan, you need to repay it too. That’s when we realize how expensive the loan was. Some don’t realize even then. Your cash flows take a hit. Your investments take a hit. You can fathom why you have nothing in your bank account at the end of the month. Only if you could go back in time, you would have not taken the loan. However, a few times, your hand is forced. You do not have much choice than to take a loan.
In this post, I will discuss such scenarios where, according to me, it is acceptable to take a personal loan and scenarios where it is foolish to take a loan.
What Is Acceptable?
- Taking a personal loan to square off an expensive loan is a smart choice. Credit card debt can cost you in excess of 40% p.a. before penalty and other service charges. This makes personal loan at 15% p.a. seem like a blessing. And it is a blessing if it helps you reduce your interest rate obligations. However, do note merely taking a personal loan does not take care of your debt problems. Personal loan needs to be repaid too. You need to review your spending behavior. You need to review how you raked up high cost debt in the first place.
- Taking a personal loan to meet a medical emergency: What good is money if you can’t use it to provide healthcare to your family? If needed, there is nothing wrong in taking a personal loan to fund medical treatment.
What Is Not Acceptable?
- Taking a personal loan for vacation. I was once asked by a reader, whether he should take a loan for trip to Thailand. Come on. Makes little sense.
- For purchasing a gadget that is way above what you can afford. By the way, if you have saved for the gadget, it is acceptable. Taking loan for such a gadget is not acceptable.
- For furnishing your house. Better plan for it and do it from your savings. A home improvement loan is another alternative.
Need vs. Want
I have discussed just a few examples. I am sure people can take a personal loan for many more reasons. It is not possible to list every such reason in this post. How do you decide what is an acceptable cause for taking a personal loan and what is not? In my opinion, it boils down to Need vs Want. You can take loan for an expense that you NEED to incur, not when you WANT to incur. You NEED to pay medical bills but you WANT the latest iPhone. You can do with a lesser expensive phone but you can’t get treatment without paying the medical bill.
I understand what constitutes Need and what constitutes Want can be subjective. You are the best judge. Remove your ego from the decision. You will get the answer. Once you have decided that you NEED to make the expense, you still need to consider another aspect. A personal loan, at 12-15% p.a. is still quite expensive. You need to see if you can use your existing savings or investments to finance the expense.
What Is Foolish?
Let’s assume you NEED to take a personal loan. i.e., the expense qualifies as a NEED. However, it is foolish to have a fixed deposit (FD) earning 8% p.a. pre-tax while you take a personal loan at 12-15% p.a. Interest income from a fixed deposit gets taxed at marginal income tax rate. For a borrower in 30% tax bracket, this is ~5.6% p.a. post-tax. So you plan to borrow at 15% p.a. while your money lies idle earning 5.6% p.a. Quite stupid. Break that Fixed Deposit and use it.
There may be a scenario when it would make a better sense to take a loan against the Fixed deposit rather than breaking the fixed deposit. If the size of fixed deposit vastly exceeds the loan amount, the interest rates have moved down from the contracted rate and there is a heavy penalty for breaking a FD prematurely, you can consider loan against a fixed deposit too. I have discussed this aspect in great detail in another post. In this case, your FD remains intact and earns interest while you repay your loan. Even though the loan fixed deposit is offered at a couple of percentage points over the FD interest rate, a loan against FD may still make sense in select scenarios.
By the way, this is not just true for fixed deposits. If you have any other asset that can be easily liquidated to fund your need, sell it. You may have an equity investment that you are gung ho about. But you must remember that your equity investment does not guarantee you a return of 15% p.a.
There is nothing wrong in enjoying life. And that’s what you earn for. However, don’t ignore the financial reality. If you can exercise discretion in taking on a new liability, exercise it. You can’t live beyond your means for too long. By the way, that should not stop you from dreaming. If you want to have a certain lifestyle, nothing wrong with it. That keeps you motivated. But you need to back up such dreams with smart planning and career choices. If you can’t afford the desired lifestyle, you need to increase your income. No two ways about it. And if you can’t do that, you need to make a choice.
You can enjoy now and struggle later.
Delay gratification, plan and enjoy throughout.