Thursday, March 12, 2009

Are you blowing up your Future today?

One of the founder fathers of United Sates of America, Benjamin Franklin had to say this for debt (borrowing) “Rather go to bed without dinner than to rise in debt.” Alas, had Americans listened to him they would not have faced current crisis.

Let us dig deeper into his statement. Statement is very strong. He is saying it is better to remain hungry than to borrow.

What is borrowing? Borrowing is nothing but spending our future, unearned, uncertain income today.

When we borrow money, we receive funds. These funds are spent today. However its repayment has to be made from our future earnings. This means we are currently spending our future income - Income which is not yet earned by us. Future is always uncertain.

To analyze it further, when we borrow we are committing ourselves to certain payout. This certain payout gets committed from future uncertain income. In short we are getting into a trap of committing certain payout against uncertain pay-in. Lots can happen between borrowing of funds and repayment. After we have borrowed, there could be slow down in economy, pay-cuts, lay-offs, health problems of near and dear ones, occurrence of natural or manmade calamites etc. Usually home loan borrowers have long repayment tenure like 15, 20 years. This is very long time and lots can become unfavorable.

In recent past, number of clients needing assistance to help manage their debt has increased manifolds. In fact many of them also needed debt counseling. These are couples who borrowed while economy was going strong. With slow-down in economy, pay cuts, and retrenchments, they are struggling to service debt.

Some of them had unknowingly leveraged themselves. After taking loan, they were paying EMI on time. However they had excess surplus deployed in equity market. Currently they are losing in equity market and also paying EMI. Had they used surplus to pay off debt, they would have been out of loan and not lost to equity.

There are some who continued (home) loans because there was tax benefit. Continuing loan purely for the sake of tax benefit is one of the biggest mistakes many make. Look at the above two calculations

While borrowing helps save tax, it also increases outflow burden due to EMI.

Usually accountants and borrowers only make calculations upto tax saved. Actually we need to go a step ahead and calculate how much funds are left in hand after servicing loan and paying tax. From the above calculations it is clear that upto the stage of tax calculations, couple with loan is better off. However moment we make one more calculation on funds available after tax, couple which did not have loan, will have more surplus.

There is no way I am suggesting do not borrow funds for basic needs like housing, health care and education. These are necessities in life, but once you have borrowed get out of it as soon as possible.

One of the prudent borrowing rule of thumb suggests that your liability should not be more than 50% of your assets. Assume total value of your house, all investments etc. is Rs 100. Your total liability should not be more than Rs 50. While borrowing, people hardly consider this. They only focus on their income and ability to pay EMI. They only focus on inflow and outflow. However as discussed earlier, if inflow was to get affected in future due to some reason, they do not have enough assets which can be liquidated to clear off debt.

More worst are those who have borrowed not to create assets but to splurge. Funds were borrowed for going on vacation, purchasing life style goods and services, there would be outstanding on credit card created because of extravagant life style etc. Even those who are servicing their loan properly but also are splurging come in this category. On balance sheet they have outstanding loan and instead of paying it back at the earliest, funds are used to splurge. It is important that we develop a habit of looking at our complete balance sheet.

Lastly when we service loan we are earning for someone else. When we pay interest from our hard earned income, it becomes income for the lender. This means we are working hard to generate income for the lender.

- Gaurav Mashruwala

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