The smart borrower…

As a smart borrower make sure you are taking the loan for the right reasons. Don’t borrow just because the interest rate is attractive or you can claim tax benefits. Here are a few basic rules to keep in mind:

Take on an EMI only if you can afford it: A smart borrower will never bite off more than he can chew. Typically different types of loan EMIs should not be more than a proportion of your monthly income. Your total monthly EMI should never go above 50% of your monthly income. Don’t take into account your future income. Times are bad, and the 10% increment you may have based your projections on could actually be only 6% or even flat, if your industry goes into a tailspin.

Type of Loan Maximum proportion of monthly income (%)
Home Loan 40
Car Loan 15
Personal Loans 10
All Loans 50

Keep the tenure as short as possible: The longer the tenure, the bigger is the interest burden on the borrower. If you take a loan at 9.75% for 10 years, the interest outgo will be 57% of the principal amount. This figure jumps to 91% if the tenure is 15 years and shoots up to 128% for a 20-year loan. In 25 years, the interest outgo is 167% of the principal. Borrowers are tempted to go for long term loans because the EMI is lower and they enjoy tax benefits on the loan. But this is a misconceived strategy because they end up paying a huge interest on the loan.

Take a simple term plan for big ticket loans like home loans: Banks usually try to push customers to buy a reducing cover term plan that covers the outstanding amount. However, a regular term plan is a better option because it continues even after the loan is repaid or if the borrower switches to another lender. Also, insurance policies linked to a loan are typically single premium plans. Regular payment plans are the best way to insure yourself.

Retirement corpus vs child’s education: Don’t dip into your retirement corpus to fund your child’s education. Education loans are easily available and bright students also get scholarships. But nobody is going to give you a loan for your retirement needs. Taking an education loan will not only keep your retirement kitty safe, but also inculcate a sense of fiscal responsibility in the child, who has to repay it. What’s more, education loans also offer tax breaks so the effective cost of the loan comes down.

Increase the EMI gradually to reduce loan tenure: This is the best way to repay say a 25 year loan in 10 years. For example:

Hike EMI by 10% every year Loan ends is in 10 years 2 months
Hike EMI by 5% every year Loan ends in 13 years 3 months
Pay one extra EMI every year Loan ends in 19 years 3 months
If EMI remains constant Loan ends in 25 years

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’