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Urban Indian is  living a life of debt- Education loan, auto loan, multiple credit cards, a home loan. What are various kinds of loans , are there some tax benefits? what are good or bad loans? How to borrow responsibly.

Young Urban India and Loan

Debt used to be a four-letter word in India. Gone are the days when our ancestors saved every penny they earned, lived within their means and considered debt as a shameful thing, to be avoided at any cost.  Now everyone seems to be exposed to some or the other kind of debt. In fact, an average urban mass middle class person typically has four-five kinds of debts in her kitty. The usual culprits are home loan, car loan, educational loan, some personal loan and our favourite – credit card dues.

Combined monthly income of Rs 1.23 lakh. Total outstanding amount on a home loan, a car loan and two personal loans at Rs 35.16 lakh. Credit card debt at a whopping Rs 3.5 lakh. This is the story of 34-year-old Phani Raj Jaligama, married to Srilata, who is also of the same age (Ref : Economic Times – Taming the Debt Monster)

Guwahati-based Ronu Mazumdar believes in living life on credit. He owns multiple credit cards and does not balk at rolling over credit from time to time. The 38-year-old businessman is currently servicing a car loan and a home loan as well. (Ref: Times of India:How to escape the debt trap

Quoting from the Subramoney’s article Children in parent’s ego EMI traps 

A guy starts earning. He first goes and buys a nice motorbike – and for that he is happily paying an EMI. Age 24 to age 27 years…and the boy is happy.

Now the pressure starts…’You are earning so well, why do you not get married’…and at age 28 that pressure translates to marriage – arranged by elders, or arranged by youngsters themselves.

Now the EMI pressure starts…’Will you take your wife with all that silk saree…and jewellery…in your bike?’ you ought to be mad. To this the father in law offers ‘Yes yes…when we were young such good EMI for cars were not available..I had to wait for the company car. It came at my age of 42′ or some such shit.

This pressure then turns to blackmail when the girl gets pregnant. That is the last straw…he HAS to buy a car. So another EMI starts.

Then the collective ego of the whole society takes over. There is pressure to buy a house. Why should he buy a house? Because his father, father-in-law, ….and every uncle, aunt, ….will feel good. So suddenly the wife will also (brainwashed by ‘society’) will say ‘When our kid is born, the kid should come to our own house’.

So now one more EMI has got added on…the housing EMI. If he protests, the father will say ‘I will put Rs. 200,000 in the down payments…or some such shit’. So pile on a Rs. 75,00,000 house has been committed to. Down payment Rs. 7,50,000 – dad pays partly, Husband and Wife clean out all their accounts and the ‘house’ has been bought. EMI? Rs. 67,000. The guys income of Rs. 134,000 is now eaten up 50% by the housing emi, Rs. 12,700 car EMI, society charges….etc etc. the monthly surplus is about Rs. 1348…and the wife’s take home is about Rs. 65,000 – which can be used for …..

The wife having connived with her parents (for the kid), and her in-laws (for the house) is ecstatic that they now have a baby on the way, a new car (it is so hot how people travel by bus and train, OMG), a new house…

Robert Kiyosaki in his book CASHFLOW Quadrant  defines urban couple – Young and upwardly mobile professional- the  Yuppie Couple. Both husband and wife earn good salaries. Set up homes with all the latest gadgets, fill up wardrobes with the best brands of clothing and accessories, having extra supplies-spare watches, shoes, upgrading TV and bikes almost with the pace they were launched in the market, eating out more, celebrating weekends, enjoying expensive holidays etc. But they have no money at the end of the month, living paycheck to paycheck. Following picture shows the life of average American which is drowned in debt. Click the picture to enlarge.

Financial Journey of an Average American

Financial Journey of an Average American (Click to enlarge)

Kind of Loans

Various kinds of loans are as follows. Understanding Loans explained about the basics of loans such as interest rates EMI, Credit history.

Personal loans are for personal needs like family vacation, a household appliance or child’s education, credit  or marriage.

Home Loan: one borrows,usually from a bank or other financial institution, to purchase a property. A home loan is a secured loan as it requires the pledge home as the lender’s security for repayment of loan. The lender holds the title or deed to your property until the loan and interest is paid back. Tax benefits are as follows :

  • Principal repayment up to Rs. 1 Lakh is totally deductible under section 80C for self occupied house unless house is in different city. (Sec 80C includes Provident Fund (PF), Public Provident Fund (PPF), life insurance payments, Equity Linked Savings Scheme (ELSS), etc – the combined benefit of all the investments under sec 80c can’t exceed Rs. 1 Lakh)
  • The interest is considered an expense under the head “Income from House Property”,hence comes as a negative amount and is deductible up to a maximum of Rs. 1.5 Lakhs under Section 24 of the Income Tax Act.

Reserve Bank of India (RBI) FAQ on Home Loans has details

Car loans are loans for purchasing a car. They cannot be used for other expenses, or for other purchases. The lender uses car as collateral to secure the loan.

Education Loans:These days education comes with a cost and higher education seems to be getting costlier day by day hence the need for education loans. Income tax benefit for an education loan is available under section 80E of the income tax act.

  • The entire interest that you pay on your education loan is deductible from your income. There is no upper limit to this amount – you can deduct the full interest paid during the year from your income of that year.
  • There is no tax benefit available for the principal that you repay.

Credit cards: The interest rates charged are significantly higher than the other loans Keeping a balance on a credit card is rarely a good idea. Credit cards are one of the worst forms of bad debt. Credit Card Debt details how people get caught in credit card debt trap?

Tax benefits and interest rates on different kinds of loans as on Oct 2012 is shown below:

Kinds of loans - interest rate, tax benefits

Kinds of loans - interest rate, tax benefits

Search and Compare Loans

Websites of banks/financial institutions provide information about the loans they offer . Other than that there are websites which help to take a well-informed decision on loan by giving choices, comparing the total costs of the loan offers, and convenience and value.Their  services are completely free for borrower, they earn revenues through partnerships with loan providers (Banks/NBFCs and DSAs) for pointing them to prospective loan seekers. Some of these websites are:

Note:This is not exhaustive list. If you know/use other website please let us know by leaving a comment and we shall update the list.

Good, Bad and Worst Loans

Is taking loan bad? Is like answering is Knife good or bad? It depends on what it is used for whether it is used for cutting vegetables, saving life(in surgeons hand) or killing someone. Just like knife, good or bad loan/debt depends on what it is taken for. If you take to purchase something that will increase in value and can contribute to your overall financial health, then that loan is a good one else a bad one.

Good debt helps you generate income and increases you net worth. For example, a home purchase can be considered to be a good debt. As homes usually appreciate in value, the loan you take out to pay for the home is an investment. Another example of a good debt is a student loan taken out to finance a college education. In general, the more education an individual has, the greater the person’s earning potential. An investment in a education is likely to pay for itself within just a few years.

Certain debts/loans are bad. When you use debt to get things that can be consumed, you aren’t accumulating good debt. Items that fit into this category include all debts incurred to purchase depreciating assets such as car,clothes, vacations, food, groceries. While you may need a vehicle to get yourself to work and to run the errands,cars, cost a lot of money for buying and maintaining. By the time you leave the showroom, the vehicle is already worth less than it was when you bought it.  bought on loan is not a good idea. Credit cards are one of the worst forms of bad debt. Bad debt creates an unhealthy financial situation.

Good Bad and Worst Loans

Good Bad and Worst Loans

While good debt may seem like a great idea, it is important to realize that even the best ideas don’t always work out as intended. Education is not a guaranteed ticket to wealth and success. Until just a few years ago, buying real estate seemed like a guaranteed win for most homeowners, as price appreciated. You must still be careful that you don’t take on too much debt, even if it’s good debt. If you’re overloaded with debt, then it doesn’t matter whether the debt is good or bad, it hurts your financial health. It is recommended that EMI for all your loans should not exceed 40% of your salary.

Responsible Borrowing

Debt is debt. The only certainty of a loan is that it has to be paid back. Loans help us to establish a credit history – good or bad.Whatever is purchased with the help of that “good” loan or “bad” loan may go up or down in value over time.  The trick is to only borrow what you need and what you can afford to pay back. Let’s look at some of the realistic and practical ideas to spending borrowed money.

Consumption expenditure – Shopping for clothes, taking holidays, eating out, spending on friends are expenses with no obvious economic outcome, except a high happiness quotient. Understand the  link between emotion and spending. Don’t use Retail therapy as panacea for all ills, from being dumped by a boyfriend to being passed over for a promotion. Things one can do to manage consumption expenses.

  • Keep track of your spending habits; maintain an expenditure diary if necessary.Take the time to prioritise .
  • Second, allocate a mental budget not in terms of rupees, but in terms of your income. If a holiday with your friends to exotic locations matters the most, allocate, say, one month’s salary in a year to it.
  • Three, make the most of this money. If you have set aside 40,000 for the purpose, do not fritter it away by booking in 5-star hotels over weekends, where your unwinding ends before it begins . Ensure you have planned well, hunted for bargains, chosen off-season timings, booked in advance and made the most of your money.
  • Do you find yourself sucked into a credit trap? Leave that credit card at home. Spending cash hurts. But, in retrospect, it can be a pleasurable pain.
  • Pay your credit card bills on time.

Consumer Durable: We have a car, a fridge, a TV or a bike to show for the debt we have assumed This is one notch above the purely emotional happiness expense. In several cases, these expenses have indirect savings, enhance our productivity and enable us to lead better quality lives. Most youngsters buy their own vehicles to commute. An air conditioner or television is no longer seen as luxury. Divide the cost of the product by the number of months for which you will use it. This is the approximation of your monthly cost. Most of these goods have limited end value and depreciate as soon as they are bought. Second, ask yourself if you can afford to spend this money as a percentage of your income.

Long-term assets: Most youngsters take an educational loan and this is best repaid before acquiring any other loan, even if it means devoting a large chunk of income to do so. Most cannot buy a home without resorting to a loan. These are necessary borrowings and result in a long-term , economically useful asset. A young earner should wait to stabilise in terms of job, location, and other long-term decisions such as marriage , care of parents, etc, before taking a housing loan. Servicing home loans over a long period is fine as long as it does not take away too large a portion of your income.

Loans to avoid:Borrowing to buy an IPO, taking margin money to play on stocks or leveraging to take on derivative positions are all speculative activities.

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Debt is debt. Whatever is purchased with the help of that “good” loan or “bad” loan may go up or down in value over time. Instead of condemning all  spending, lets look to nurture the habit of doing so responsibly. But be in control of your debt – don’t get sucked into debt trap. If you’re overloaded with debt, then it doesn’t matter whether the debt is good or bad, it hurts your financial health

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