Good Loans, Bad Loans and Ugly Loans
Can loans be good loans, bad loans or ugly loans? People who are currently in their 30’s will remember how the previous generation including their parents, uncles/aunts, etc, used to tell them that borrowing is bad.
Taking a loan was seen as a risky proposition. It was as bad as gambling, betting or reckless expenditure.
The idea of taking a loan from personal sources or from banks or financial institutions was avoided or dreaded most of the times. Now, when we turn the time machine forward by 3 decades, things have changed dramatically.
Today, there are loans for all types of needs whether you want to spend on groceries or want to take a holiday, you have loans or credit facility to back on. Similarly you can buy your favorite car, shoes, apparels, home, etc.
Case of Bad Loans
Due to the easy availability of credit people try to buy or use it instantly to get their needs satisfied instead of saving, budgeting and prioritizing their expenses.
For instance Sumeet (illustrative name) was always keen on buying a car. He was working for an MNC company and had a good salary and savings. However, whenever he met his friend Ashish (illustrative name), who drives a Honda City he always felt he wanted to have a car.
Although Sumeet could not afford it, but his wife advised “Sumeet you are far more intelligent, qualified and better off compared to Ashish………..so you need to have a high-end car.”
Sumeet’s friend who was an expert on cars suggested that he go for Honda Accord. Sumeet fixes a deal. He had to shell out a few lakhs and five digit EMIs every month. Today he hardly uses his car due to high traffic and petrol costs, and ends up using a two-wheeler to office while the car is used only once or twice in a month! Was Sumeet really wise in taking this decision? Will he be happy about this decision? Not really.
This case clearly shows how Sumeet was forced to get in to a bad loan (or an ugly one) and suffer from it. One he had to deplete his savings to arrange for a down payment.
Two he is now paying 5 figure EMIs for the car. Finally, you have maintenance, repairs and ancillary expenses to make this worse.
Identifying Good loans, Bad loans, and Ugly loans
It’s difficult to tell if a person is good or bad unless you know him or her quite well and are familiar with his or her character and behavior. Similarly, it is difficult to put loans into good loans, bad loans and ugly casting. Let me give you an indicative checklist to help you in identifying these.
|Characteristic||Good Loans||Bad Loans||Ugly Loans|
|1. Interest Rate||Low||Medium||High|
|2. Repayment Terms(Tenure, EMI, etc.)||Reasonable||Variable according to type of loan||Variable according to type of loan|
|3. Security/Collateral||Yes||Could be secured/unsecured||Unsecured|
|4. Legal consequences||Minimal||Moderate||Problematic|
|5. Does it help in building productive assets that appreciate in value overtime?||Yes||No (may help acquire assets, which depreciate)||No (no assets, just expenses to deal with)|
|6. Is the end-use of the loan meant for purchasing asset that generates income or cash flows?||Yes||No||No (no assets, just expenses to deal with)|
|Examples||Housing Loan, Educational Loan*||Car loans, consumer durable loans||Credit cards**, Personal loans|
Notes: Facilities such as loan against shares, loan against gold, etc. beyond the scope of this article, hence they are not covered.
* In case of educational loan the last 2 characteristics are true and applicable, because education/qualification is an asset and it delivers value or benefits overtime.
** Credit cards can still be used provided one avoids rolling over their outstanding balance.
This classification is based on the risk or the potential damage that a loan can cause to you. An ugly loan is highly risky, while bad loans have moderate risk. The good loans are the ones you can still continue to have as long as you are able to repay it comfortably.
Debt (loan) Management
Once you have identified good loans, bad loans and ugly loans you have to see which ones needs to be paid faster. The key is to make sure that you eliminate or minimize on bad loans and ugly loans as soon as you can.
To give you a broad idea assuming you have loans such as housing loan, car loan, consumer durable loan, credit cards and personal loan, the priority of payment (settlement) would be as follows:-
- Credit cards
- Personal loans
- Consumer durable loans/car loans
- Housing loan
Does this really work? Ideally it should, but practically it doesn’t. Invariably in most cases credit card payments can be postponed. Hence, you will be forced to make other loan payments and run your household expenses on credit cards.
And, overuse of credit cards can further drag you in to a debt trap. The best way to deal with these situations is not to have too many loans in the first place. If you happen to be in a problem the remedy would be as follows.
When you see several loans piling up, you must seriously think about paying off or closing the high-interest loans such as credit cards (3.5% per month, 42% p.a.) or personal loans (18% p.a. or more). The next step is to just make sure you pay car or consumer durable loans as per schedule and close them.
If the car or consumer loans are long tenure you can use your bonus, extra income or other sources to close them when it is feasible within your budget. You can either do a partial or full prepayment (or foreclosure) for these loans.
Now, what about the housing loan? This is a loan that goes towards building an appreciating asset that grows in value and can provide rental income or savings over the long run. In addition, housing loan payments have tax rebates.
Hence, you don’t really have to worry about prepaying or closing a housing loan unless you have a emergency need for a large amount of funds. Sometimes party pre-payment also helps you to reduce your EMIs or tenure when interest rate goes up.
Key Message about dealing with loans
When dealing with loans, being proactive is important, because once you get in to a trap it’s difficult to come out. There are cases were people have got in to sever debt traps and had to sell their valuable assets such as property, stocks, deposits that are worth several lakhs of rupees.
It takes many years to build assets and income streams, but a few small mistakes in your credit habits can ruin all your incomes and assets. So it is very important to keep your loans or credit facilities to the minimum or a reasonable limit.
Some key things to keep in mind about different types of loans are below.
- Personal loans are a strict no-no. There are exceptions where these can be used, but generally speaking avoiding one is always a good financial habit.
- In case of credit cards you have to avoid rolling over your balance and pay your bills on time. If you roll over your balance during a bad phase, try to make up and pay for it as soon as possible to avoid the beginning of a debt trap.
- Loans for cars and consumer durables are also not recommended. If you have availed these facilities, it is not a bad idea provided you can comfortably pay them using your regular income sources.
- Housing Loans: This loan is a productive one used for asset building and for creating an income/saving stream. Many people try to partially pay a housing loan, which can be good to tackle growing EMIs, however, even if you don’t pay prepay a housing loan, you are gaining a lot of benefits since you are borrowing for a low rate of interest over a long period. Given this scenario if you factor things like rental savings, tax benefits, etc. the loan is beneficial in the medium to long run.
Conclusion – Good loans, Bad loans and Ugly loans
Many people have the wrong notion that they are privileged or entitled to get a loan/credit facility given their education, job, income and personal status.
This could be true to some extent, but lets all realize that all lenders be it banks, finance companies, etc. are all in the business to provide a facility and charge a fee or interest or both to the consumers (like you and me) who take loans or finance their purchases using credit facility.
Taking a loan can be a good financial proposition only if you can use the loan and deploy it to get a higher rate of return (i.e. you borrow at 12% and make 20% return by investing, doing business, etc.). Are you really capable of doing this? If yes do you have a business plan or actual business operations with a good profit track record?
If your answer is ‘No’, then obviously taking a loan and financial benefiting out of it is just wishful thinking.
The only exception to this for ordinary people would be a housing loan which has the potential to generate returns in the form of capital appreciation or rental income. So, to sum up all loans are not financially beneficial, but they just provide a facility to buy now and pay later.
To put it in a crude simple language taking a loan is like using an expensive cab or limousine, which is a facility that is meant to be used for certain occasions or events. If you smartly use loans for the right occasions and pay them off they are not necessarily bad.
It is always safer and smarter to be a little more conservative and try to live within your means and abilities and focus more on building assets and incomes rather than building loans and expenses. You have the power to decide – so make your choices carefully.