Reassessing your financial strategy before opting for a big ticket loan
“All the time that I had the burden of my home loan hanging on my head, it made me realize that all my financial plans had gone awry because I didn’t bother to plan things in great detail before I sought a loan from the bank. The oversight of how EMI payments would have a trickle-down effect on other aspects of my finances continues to haunt me and when the pandemic hit, things just got infinitely worse.” For Anshul Choudhary (name changed), the COVID-19 pandemic couldn’t have come at a worse time. The 35-year-old management professional and his wife welcomed a baby in early 2019 and soon after the couple decided to purchase their dream home.
Getting a loan from the bank was a smooth experience. Choudhary had envisaged that his wife would start working again and that he would also be able to switch to a better paying job with ease so that their increased incomes would make the debt burden a little less painful. However, the coronavirus pandemic came as a rude shock and much to the couple’s dejection, servicing the EMI payments became a Herculean task what with his wife not finding a job and Choudhary facing the brunt of a pay-cut.
While easy availability of credit is a boon, it is also a two-edged sword. The knowledge that you can easily tap into a credit reservoir for fulfilling your goals and repay it later on can create a misplaced sense of complacency which leads many people to sign up for a debt load that may not align with their financial capabilities.
Knowing your repayment abilities
Anuja Agarwal, managing director at InvestAscent Wealth Advisors Pvt Ltd believes that the biggest question to ask before availing a big ticket loan is to ask how that decision affects other areas of your finances. “It is always important to look into the holistic aspect of any decision we make, whether it is our health, business, career, home and especially finance. Taking loans for fulfilling our desires is the easiest thing to do today but one must ask oneslf: can I afford that loan? If yes, what happened to my other critical goals?”
While assessing your repayment abilities, it is also important to not give in to the temptation that its okay to divert financial resources for other goals towards loan repayment. Agarwal says, “Investments towards goals like children’s education, retirement, emergency medical expenses should not be compromised for the sake of paying EMIs, especially if the debt has been taken for indulgences or recreational activities. Before taking a loan, make sure that you would be able to manage your regular expenses and investments while repaying the loan.”
Parvati Iyer, chief investment officer at Femwealth.com, an online investment management platform believes repayment abilities is the first thing one should consider before deciding to take the loan route. “Anytime one takes a large loan, the ability to pay it back must be determined. A little bit of planning can go a long way in ensuring that you don't find yourself in a situation that only gets worse over time. This means that there is sufficient income to cover the EMIs. The best case is obviously to save and invest towards the goal of that big ticket item. But since that may not always be possible, one needs to look at current income versus outgo. Your current financial strategy would have included investments in equity and debt mutual funds towards the goals you aspire to meet. One of the first things to check is whether the investments in the current goals can be continued without any interruption,” she explains.
Tweaking your investment plans
SIPs in mutual fund investments can drastically reduce your EMI burden. While many people tend to forego investments in favour of shedding off their debt load after having taken a big ticket loan, a dedicated SIP plan, even if it is of a nominal value can go a long way in shrinking the amount you would be paying as interest to the bank. For instance, if you avail a home loan of ₹25 lakh at an interest rate of 9% per annum for a tenure of 20 years, you will approximately have to repay ₹54 lakh by the end of 20 years and your EMI will hiver around 22,500. Now if you invest even 0.1 percent of that ( ₹2500) in an equity fund through SIPs and assuming it delivers a 12% rate of return, your investment would amount to ₹24.7 lakh in twenty years and this capital appreciation on your investment will significantly offset the interest on your home loan.
Iyer suggests that if a situation arises where one is being forced to compromise on the current investment outgo, then it may help to compare the return rates projected for a few goals with the loan rates. “Typically loan EMIs tend to carry an interest rate above debt fund returns. Most short term goals tend to be funded by debt funds. Therefore your amended financial strategy should consider delaying some of the short term "wants" such as a vacation abroad. As a worst case, key goals such as retirement may need to be delayed by a few years to accommodate the reduction in investments while maintaining the same asset allocation. However the calculations may render such goals untenable, in which case it is best to avoid the big ticket loan. Changing asset allocation or projected rate of return to fit your financial strategy is guaranteed to be a disaster,” she says
She highlights that for the long term, the comparison exercise should also factor in expected returns from equity mutual funds because they are mostly suited for long term investments and expected income increments also if possible. “In general for a plain wealth creation goal, if your projected returns from equity mutual funds is higher than the loan rate then equity investments could be continued at the expense of longer loan terms. It is best to make such comparisons over a longer investment horizon wherein the ripples in equity return can be allowed to stabilise. If you have good visibility into future income increments, then the increments could be factored into your financial strategy as well.”
• When you opt for a big ticket loan, you should make sure that your emergency fund has enough to accommodate EMI repayments for at least six months.
• Never underestimate the power of a good term insurance policy for you and your family. There cannot be a worse financial nightmare than not having funds to cover for any emergencies. When you sign up for a big ticket loan, it may become harder to tide through such circumstances without the buffer of an insurance policy.
• Keep a close eye on your credit score and if possible clear off your credit card debts and existing loans that are smaller before availing a big loan.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.