Sharing this article which appeared in DNA
Traditionally, Indians are great savers. The credit to GDP ratio in India is one of the lowest in the world, and we generally think of loans in a negative way. However, a loan is nothing but a leverage in your hands and can be good or bad, depending upon the purpose for which it is borrowed. Think about it.
Companies take loans from institutions and individuals to make profits. Even your trusted neighborhood bank takes loans in the form of deposit from you and generates higher returns by lending it to borrowers, thus creating positive leverage and profits.
Accessing loans means using someone’s money for an end purpose by you and paying the price for it. If you make good use of it, the same can generate more money in your hands and vice-versa. Thus, good loan is a loan that puts more money in your pocket and bad loan is a loan that robs money from your pocket. For example, taking home loan at low interest rate and putting it on rental where the rental income is higher than interest outgo is a good loan as it creates more money in your pocket whereas buying the latest smart phone on EMIs is a bad choice as you are taking loan to buy depreciating asset and getting money out of your pocket.
In general, taking loan to buy an investment asset is good loan if it helps create passive income more than the interest amount, thus creating positive cash flow. If the passive income net of tax creates positive cash flows after accounting the interest outgo, it is an excellent investment asset for positive leverage. Avoid any asset that that does not create income. Moreover, if it is depreciates, it creates further problem. Lastly, the more leverage you can take for an investment asset the better it is – for example, leverage on real estate is generally more than equities.
Now let’s take a look at some examples of good and bad loans.
The Good Ones
— Taking loan for funding an acquisition or investing in a business generating better IRR than the loan interest rate.
— To invest in a property with rental income better than interest outflow.
— For investing in equity or IPO with expectations of good dividend income and long term appreciation.
— Taking a loan on the existing house and investing in assets that create good passive income and long term appreciation.
— Education loans to pursue a degree that gets better paying jobs in future.
The Bad Ones
— Taking loan for buying car or the latest gadget.
— Revolving credit card balances.
— Personal loan to fund the next vacation.
Watch out for few trends to get it right when taking loan or creating leverage. Generally speaking, a good time to take loan is when the economy is doing well, interest rates are benign and inflation is moderate, leading to lower interest outflows and appreciating asset values.
Another aspect that needs to be kept in mind is credit score as frequent borrowing and any delay in payments can lead to deterioration in credit score, which ultimately impacts the borrowing capability and attracts higher rate of interest on future loans.
Loans can be good or bad depending on the purpose for which they are taken. Simply put, any loan taken for investing in an appreciating asset which helps you create a passive income higher than interest paid post tax is an excellent positive leverage. But do not let the good ones turn into bad with longer repayment tenures and unreasonable interest rates.