The banking sector has seen many technological advancements over the past few years. Online aggregators now assist customers in identifying the most cost-effective loans, while banks can approve and disburse loans in less than a minute.
Even as technology transforms the loan disbursal process, the fundamental principles of taking loans responsibly remains the same. Here are eight golden rules of borrowing that prospective borrowers should adhere to.
Don’t borrow more than you can repay
The first rule of smart borrowing is to refrain from exceeding your financial capacity. Choose a loan that you can comfortably repay. A commonly recommended benchmark suggests that car equated monthly installments (EMIs) should not surpass 15%, and personal loan EMIs should not exceed 10% of the net monthly income.Amidst intense competition among banks to attract business, obtaining a loan may seem as simple as ABC. However, it’s crucial not to take a loan solely because it’s readily available. Ensure that your loan-to-income ratio remains within acceptable limits before making a borrowing decision.
When a significant portion of your income is consumed by EMIs, it can potentially jeopardize other essential financial objectives such as saving for retirement or funding your children’s education. In such circumstances, retirement planning is often the first casualty. It’s essential to strike a balance to ensure that loan repayments do not unduly hinder your ability to meet crucial long-term financial goals.
Keep tenure as short as possible
While major lenders offer a maximum home loan tenure of 30 years, the allure of lower EMIs often leads individuals to consider opting for a 25-30 year loan. However, it is advisable to choose the shortest tenure within your financial means. The interest outgo on a long-term loan is significantly higher. For instance, on a 10-year loan, the interest paid is 57% of the borrowed amount, escalating to 128% for a 20-year tenure. Opting for a 25-year loan of Rs 50 lakh results in an interest payment of Rs 83.5 lakh (or 167%). While longer tenures may be necessary for individuals with lower incomes, a prudent strategy is to increase the EMI annually in tandem with income growth.Raising the EMI amount can significantly impact the loan tenure. Assuming an annual income growth of 8-10%, adjusting the EMI proportionately should be manageable. For instance, if someone borrows Rs 50 lakh at 10% interest for 20 years, the initial EMI would be Rs 48,251. By increasing the EMI by 5% each year, the loan could be paid off in less than 12 years. Further tightening the belt and boosting the EMI by 10% annually would result in clearing the loan in just nine years and three months. This approach can be an effective strategy for borrowers looking to expedite loan repayment.
Ensure timely and regular repayment
Maintaining discipline, especially in the timely repayment of debts, is a wise financial practice. Whether dealing with short-term obligations like credit card bills or long-term loans for a home, it’s crucial to avoid missing payments. Failure to meet EMIs or delaying payments can significantly impact your credit profile, potentially hindering your ability to secure loans for future needs. Prioritize your financial commitments, ensuring that loan EMIs are never missed, even if it requires temporary sacrifices in other investments. In emergencies, focus on settling your dues promptly. Notably, missing credit card payments incurs non-payment penalties and hefty interest on the outstanding amount, underscoring the importance of timely repayment.
When you lack the funds to settle the entire credit card bill, consider paying the minimum of 5% and carrying over the remaining balance. However, it’s essential not to make this a habit, as credit card debt, with interest rates ranging from 24-36%, is one of the most expensive forms of borrowing. To ensure you never miss the due date, set up standing instructions with your bank to automatically pay the minimum 5% whenever the bill is due. This helps in avoiding penalties and mitigates the risk of accumulating high-interest debt over time.
Also read: 7 types of loans you can avail if you need funds quickly
Don’t borrow to splurge or invest
A fundamental principle in investing is to refrain from using borrowed money for investment purposes. Ultra-safe investment options like fixed deposits and bonds typically yield lower returns compared to the interest rates on loans. On the other hand, higher-return investments like equities come with volatility. If the markets experience a downturn, not only may you incur losses on your investments, but you’ll also be burdened with loan EMIs. It’s advisable to invest with your own funds to avoid the added financial risks associated with borrowed money.
Keep shopping for better rates
Managing a long-term mortgage should not be a set-and-forget endeavor. Stay vigilant and informed about new regulations and fluctuations in interest rates. Continuously explore the market for the most favorable rates and consider switching to a more affordable loan if feasible. However, ensure that the interest rate difference is substantial, preferably at least 2 percentage points. This precaution is necessary to offset potential losses from prepayment penalties on the old loan and processing charges associated with the new loan.
Initiating prepayments sooner can have a more significant impact on reducing the loan tenure. While the RBI prohibits banks from imposing prepayment penalties on housing loans, it’s important to note that penalties may apply to other types of loans. Certain lenders may waive prepayment penalties if the payment amount does not surpass 25% of the outstanding amount at the start of the year. This information underscores the importance of understanding the specific terms and conditions of your loan agreement when considering prepayments.
Also read: Home loan interest rates may fall by 50 bps or more in 2024; how to save more on your loan
Substitute high cost loans
Managing multiple loans can be simplified by consolidating them into a single, low-cost loan. Begin by listing all outstanding loans and identifying the higher-cost ones that could be replaced with more affordable options. Consider utilizing a loan against property to repay all other outstanding loans. Alternatively, explore options like gold loans or loans against bank deposits. It’s also advisable to prioritize prepayment of costly loans at the earliest opportunity. Redirect windfall gains, such as annual performance bonuses, tax refunds, and maturity proceeds from life insurance policies, towards repaying these high-cost loans. This approach helps streamline debt management and potentially reduces overall interest expenses.
Don’t nix retirement by avoiding loans
Financial goals, particularly those related to children, often evoke strong emotions among Indians. Parents, given the choice, would prefer not to burden their children with loans, especially for education. While securing your child’s future is a priority, it’s crucial to assess the potential impact on your own future. Tapping into your retirement savings to fund your child’s education can be a risky proposition. Students have various options such as loans and scholarships to cover educational expenses, but there’s no similar support system for planning your retirement needs. Your retirement is equally important, if not more so, than your child’s education. It’s essential to avoid planning for your children in isolation; instead, integrate all your financial goals into your expense planning to achieve a more balanced approach.
Keep spouse, family in loop about loan
Before committing to a loan, it’s crucial to have a discussion with your family. The repayment of a loan can significantly impact the overall financial dynamics of the entire household. Ensure that your spouse is well-informed about the loan and understands the reasons for taking it. Keeping a spouse in the dark about financial matters not only adds stress to a marriage but also hinders the chances of finding more cost-effective solutions. Perhaps your spouse has some extra funds that could potentially help you avoid taking the loan altogether. Don’t miss out on such opportunities by keeping your financial needs hidden. Open communication within the family can lead to better financial decisions and outcomes.
