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When a loan doesn’t hurt…

Going to a financial planner for the first time? Be ready for this question – How much have you borrowed?

But a financial planner won’t consider all loans as bad. If there is a big amount on the credit card, he will ask you to pay it immediately. If you are short of cash and the bill is too high, he may even advise you to take a personal loan. After all, a personal loan comes at 15-20 per cent whereas credit card companies charge over 40 per cent annually.

But some loans like an education loan have actually created an opportunity for the generation to fund themselves even before they are earning. Any loan, if used well, improves your lifestyle.

  • It is for an appreciating asset, like a house
  • It is for education since it helps build capital value
  • It helps to save tax
  • It helps to  build financial discipline

Creating assets
Whether you want to buy an automobile, house, consumer electronics, household appliance, or a gadget, a loan can help fulfil that goal. In other words, if one has the ability to pay back and does not have enough cash to pay the entire sum of money, a loan will help an individual by increasing his affordability. It makes his goals achievable. It boosts his capacity to acquire assets. It gives an individual confidence to fulfil his materialistic aspirations.

Provides tax advantage
There are two loans that immensely help an individual by getting her some tax relief. These are home loan and education loan. Any time any individual takes a home loan from an HFC (housing finance corporation) the interest that he pays and the principal payback up to Rs 1 lakh gets exempted from tax liability every financial year during the lifetime of a loan account. The interest amount is capped at Rs 1.5 lakh if it is for a self-occupied house and if it is for a let-out property, there is no cap on the interest amount exempted from tax. Home loans in India, given the Indian economic situation i.e. housing needs and tax laws, create financial leverage for home owners. These exemptions are defined under section 80(C), 24(a) & 24(b) of tax rules.

Even the repayment of interest on education loan provided that the loan was taken for the higher education of self or spouse or children or the student of whom the individual is a legal guardian, can be claimed for deduction under section 80(E). An education loan creates a culture encouraging youngsters to pursue their academic dreams and not feel paralysed due to unavailability of funds at their personal level. This deduction u/s 80(E) is allowed only if the education loan is taken from any financial institution or approved charitable institution. Education loans from relatives and friends do not qualify. Also, the exemption u/s 80E is allowed to be claimed in the year in which the individual starts paying the interest on the education loan and in seven succeeding years.

Building credit history/score
Any loan taken from a financial institution puts the borrower’s PAN under observation throughout the loan period. The Cibil (Credit information bureau of India) collects transaction details of every borrower from the financial institution that lends the money to the borrower. Since the records are centralised with Cibil, every bank before processing a new application checks the applicant’s PAN with Cibil to check if the borrower has had any defaults on his part on previous loans. The credit score plays a critical role in the loan approval process. An individual’s Cibil credit score provides a credit institution with an indication of the probability of default of the individual based on his/her credit history that is, the past pattern of credit usage and loan repayment behaviour. Credit history is an important part of financial record. And loans play an important role in building one’s credit history.

Inculcating a sense of financial discipline
When an individual is taking a loan he is giving a commitment to the lending institution to pay equated monthly instalments for the lifetime of the loan. He is ensuring that his accounts have sufficient balance to pay an instalment every month for the loan he has taken. This builds a sense of financial discipline in the person. The person also understands that if he defaults, he would be ruining his credit record with Cibil which will make his/her new loan applications in future difficult to get approved.

Financial independence
Gone are the days when you would turn to family and friends for financial help. With the loan eligibility an individual can always borrow money from a lending institution and set out on the path of financial independence. The only favour you would need from your close relatives and friends is to ask them to be your guarantor and assure them of your repayment capability through EMIs. Loans have helped people become responsible and mature in their financial transactions. On a softer side it has benefited individuals become confident and competent in managing their financial life.

When should loans be avoided? Watch out for the following when deciding to take a loan.

  • Is a loan being taken for an appreciating asset or depreciating asset? Any loan taken on an appreciating asset like a house or education loan that builds human capital value, creates financial leverage i.e. the borrowed money creates more money than it costs. Tax exemptions, capital value appreciation and increase in human capital value drive leverage. Loans on depreciating assets like electronics and cars must be avoided unless you don’t have the lump sum to make 100 per cent down payment.
  • Is this loan an unsecured one? Home loans and auto loans (commonly known as secured loans) are likely to be better than unsecured loans because secured loans are cheaper and secured loans impact one’s credit score favourably. Credit card loans and personal loans are two prime examples of unsecured loans that must always be avoided.
  • Is a loan being offered at a competitive rate? Understanding the cost of borrowed money is very important. If the loan product is not competitively priced, it must be avoided.

The author is founder, WealthBeing Advisors


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