To Loan or Not to Loan?

Here is the transcript if you would like to read it instead:

Ram: Welcome back to Kairos, a podcast on financial planning where we talk about doing the right thing at the right time. My name is Ram and I have Namratha with me today to talk about the topic “To loan or not to loan”. Hi Namratha.

Namratha: Hi, Ram and hello to everyone who is listening in today.

Before we begin, I have this week’s poll results with me. For those who are new to our podcast, we run polls on LinkedIn in the first week of every month, and we discuss them here in detail. So, this week, we asked our community to take part in the polls. Here are the results:

• • • • • Poll 1: What do you think is the most common reason for taking a loan?

Not a surprising answer here, taking a loan to buy a house comes out far ahead of the second option of buying a car.

• • • • • Poll 2: Which loan do you think has the most tax benefits?

The poll answer came out to be a housing loan, which indeed would come with the most benefits.

• • • • • Poll 3: What factors do you consider the most before availing of a loan?

The options in the poll were interest rate, duration of loan & Tax-benefits, and pre-payment fees with a fourth option as all the above. The poll results came out to be all the above as these are all important factors one should consider before opting for a loan.

This is interesting. What do you think of these results, Ram? Can you throw some light on some of the common reasons for taking a loan?

Ram: It’s evident from the poll results that the most common reason for availing of a loan is to buy a house. A big-ticket purchase such as a home to live in can often be too expensive to purchase out of pocket and going for a home loan might be the only option for most people.

Adding to this, buying a home can be beneficial from a taxation standpoint as well. We will talk about this in detail later in the podcast.

Not surprisingly, the second most common reason to avail of a loan is for education. Education plays a pivotal role in the life of many Indians and pursuing higher education programs such as a master’s would often involve taking a loan as the cost of higher education especially if choosing to go abroad would be quite expensive.

Namratha: What do you think about the general stigma around taking a loan? Is taking a loan always a bad idea?

Ram: That’s a great question, Namratha. The general perception is that loans can cause more problems than solve any. Taking a loan is essentially looked at as spending your future income. Most people find themselves spending a good amount of their salary on paying off their EMIs. Though this is true, a case can be made for the other side as well.

So, are loans bad? The answer lies in the WHY – Why do you need this loan? Understanding why you need a loan & if it’s necessary is key. Taking a loan to buy an asset or funding one’s education, at face value, is considered productive.

Let me give you an example. Say, Mr A is taking a loan for the purchase of a house. He is planning to rent out the space. Taking a loan, in this case, makes sense for the following reasons:

1. 1. 1. 1. 1. Buying a house is a big-ticket purchase, and it’s not always possible to pay out of pocket.
            2. The house could be considered an asset that could appreciate over time.
            3. As Mr A plans to rent out the place, he can make use of the asset to generate income.

Another point that can be considered, is taking something like a housing loan for half of the amount and paying the rest out of pocket. Since housing loan interest rates are usually lower than the returns that can be expected from equity investments, this additional amount can be deployed in equity-related investments to earn some additional return over and above the interest rate on the loan.

Please take into note that, equity-related investments are volatile and are subject to market risks such as loss of capital, always consult a SEBI-registered investment advisor before investing.

Namratha: That’s a good point, Ram. But what about taking a loan for other requirements that we do not consider an asset? Something like a personal loan?

Ram: Taking a loan is not always bad. But one should understand fully what they are getting into. A personal loan when taken to buy a new TV or phone is not recommended, since these are depreciating assets, whose value would only go down over a period.

But a home loan which is taken to buy a house or a piece of land is considered an ideal investment as the value of the house or land can appreciate in the future.

Another scenario can also be considered where buying a very expensive house and paying a major part of your income through EMI can be detrimental to your finances, in that situation it would be better to stay in a rented space with comparatively lower rent and invest the difference

amount in a combination of equity and debt instruments, which can allow you to afford your own home in the future.

Let me put it like this, taking a personal loan that has an absurdly high-interest rate which is between 10.5-16% should only be considered when all other options have been exhausted. These loans with their high-interest rates are often the reason why people end up getting stuck in the debt trap.

Instead of going for a personal loan, people should look to meet their expenses and needs from their existing assets and cash flow. They can even consider selling some investments to meet their expenses in case of an emergency. A personal loan should only be considered as the last resort after all available options have been exhausted.

Next, we come to the motor vehicle loan. For most people owning a car or bike can be a childhood dream. While a car or bike is a depreciating asset, the convenience offered by them should also be considered before outright rejecting such a purchase.

If you can manage to afford a vehicle without a loan that would be the best-case scenario. On the off chance that isn’t possible an optimal situation here would be to go for a balance between owning a vehicle and taking a smaller loan that would be easier to service.

Namratha: I also want to add to this that, loans on depreciating assets such as motor vehicles can be considered for a lower tenure such as 3-4 years where the interest paid on these loans would be lower, but even in that case, a down payment of 35-40% of the value of the vehicle or more can help you significantly save on the interest outflow.

Ram: Alright, next let us look at what kind of benefits people can expect if someone is taking a home loan or an educational loan, from a taxation standpoint. If you could share some thoughts.

Namratha: Well, home and education loans do provide tax benefits. These are in the form of deductions on taxable income.

For home loans:-

• • • • • The interest portion of the EMI paid for the year can be claimed as a deduction from your total income up to a maximum of Rs 2 lakh under Section 24.
        • The maximum deduction for interest paid on self-occupied house property is Rs 2 lakh.
        • For let-out property, there is no upper limit for claiming interest.
        • Deduction on interest paid towards home loan during the pre-construction period in five equal instalments starting from the year the property is acquired or construction is completed, over and above the deduction you are otherwise eligible to claim from your house property income. However, the maximum eligibility remains capped at Rs 2 lakh.
        • The principal portion of the EMI paid for the year is allowed as a deduction under Section 80C. The maximum amount that can be claimed is up to Rs 1.5 lakh. But to claim this deduction, the house property should not be sold within five years of possession. Otherwise, the deduction claimed earlier will be added back to your income in the year of sale.

Besides claiming the deduction for principal repayment, a deduction for stamp duty and registration charges can also be claimed under Section 80C but within the overall limit of Rs 1.5 lakh on the year, the charges were incurred.

For education Loans:-

• • • • The interest paid on an education loan is allowed as a deduction from the total income under Section 80E. However, the deduction is provided only for the interest part of the EMI. There is no tax benefit for the principal part of the EMI.

I know this is a lot to take in. you can follow us on our socials for a comprehensive infographic with the points mentioned above.

Ram: Thanks for that comprehensive overview of the tax benefits that can be availed. I am sure our listeners can avail of these deductions if not availed already.

Namratha: Yes, Ram. I have another question along those lines… Could you shed some light on the key aspects one should consider before taking a loan?

Ram: Certainly,

• • • • First and foremost, is the interest rate on which the loan is taken. This is an area where through proper inquiry with multiple banks and financial institutions people can negotiate a lower rate of interest on their loans ultimately resulting in lower EMI payments.
      • Secondly, the duration of the loan must be considered. Opting for a loan with a higher tenure such as a car loan with 7 or 8 years to maturity can lead to higher interest outflow in the form of EMI.
      • Thirdly, tax benefits and pre-payment charges. If you plan on closing your loan earlier than expected be ready to pay additional charges in the form of pre-payment fees. Though these are not significant amounts, nevertheless a good practice would be to consider these charges before you take a decision.

Ram: In addition, adequate due diligence must be done before finalizing the loan as a loan entails a long-term commitment to pay off the dues. It is always a good idea to read the fine print and speak to your advisor before taking on a loan. An advisor could also help bring your needs, wants, and financial goals into perspective and help you make sound financial choices.

On that note, we conclude this episode of our podcast. See you on our next episode!

Join our polls on LinkedIn or Twitter. Follow our handle @ithoughtplan for more updates. See you again next month!

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