Debt: Your best friend or worst enemy?
We have all borrowed money at some point of time in our lives. It may have been a small amount from a friend when you were short of cash or a loan to buy a home. However, the most commonly used form of debt is credit cards where the bank gives you credit to be repaid by the end of a credit cycle.
Is debt bad?
Debt is a two edged sword - you see great wealth being created and you also see many families taken to the cleaners because they did not know how to use debt wisely.
If one asks, ‘Is television bad?’ The answer would be: No as it entertains, provides news etc. And yes too because it takes up time which could be used more productively, it could strain the eyes etc.
Similarly, debt, when used the right way can help you build assets (can you imagine buying a home without the aid of a loan?), but, it can also pull you down if used the wrong way. Debt is not bad if it used to build an asset and is repaid on time.
The hidden cost of borrowing
Borrowing costs money. The longer you owe money, the more it costs. That is why it is important to pay it off as quickly as you can.
There is an important reason to avoid or reduce your debt. When you pay back a loan or a credit card, you are paying it back in after-tax rupees. In other words, you must earn money to pay back the debt amount plus the interest, and you must also pay taxes on that money. If you are in the highest tax bracket, you may have to earn more than Rs 1,500 to pay off a Rs 1,000 debt.
Use debt in the right way
- Avoid costly interest charges. You may pay a higher rate of interest on a debt than you would likely make on an investment.
- Start growing your savings. Even if the debt you have does not charge a high rate of interest, the sooner you pay it off, the sooner your money can start earning interest.
- Worry less about money. If you have debt, you may feel a lot of stress trying to find the money to pay your bills each month.
- Get more credit if you need to borrow in the future. If you fall behind on paying off your debts, you will have a hard time borrowing more money next time.
- With a credit card you enjoy an interest-free loan. If you pay your bill in full every month and your card has a grace period, you are actually getting an interest-free loan. If you buy something a day or two after your card's billing ending date, it can be 30 to 52 days before you will have to pay for it. Just make sure you have the funds ready when the bill comes in or you could end up paying a lot of interest.
- Credit cards usage helps you build up credit history which will aid in getting better rates for loans when you so require.
The author is a credit expert with 10 years of experience in personal finance and consumer banking industry and another 7 years in credit bureau sector. Rajiv was instrumental in setting up India's first credit bureau, Credit Information Bureau (India) Limited (CIBIL). He has also worked with Citibank, Canara Bank, HDFC Bank, IDBI Bank and Experian in various capacities.
Photographs: Uttam Ghosh/Rediff.com