A loan is often misunderstood to be an avenue to borrow funds only for people who cannot afford to bring in money.
However, wealthy people also often use loans to achieve their financial goals, due to its benefits.
A loan is simply an arrangement wherein the funds borrowed is used for a particular purpose -- be it to buy a home, buy a car or fund your child’s education.
Loans help you achieve your financial goals, even if you do not have 100 per cent of the funds needed for it immediately.
In other words, you can incur the expenditure that you wish, whenever you feel the need for it, and repay the amount borrowed little by little over a period of time.
People who take loans usually are of two kinds.
The first kind is those who display either extreme affinity or extreme dislike towards taking a loan.
The other kind is those taking a more balanced approach, who borrow funds, but prepay the loan as early as they can.
This brings us to the next question -- when to prepay the loan and when not to, such that you maximise your wealth-making capacity?
There are several borrowers, who prefer to part-prepay or fully prepay theloan as soon as possible, because the thought of being in debt is not very comforting.
While prepaying is a personal decision, it may notalways make financial sense to prepay the loan.
So when should you prepay your loan and when not?
You should always look at the opportunity cost of your money before taking this decision.
Let’s say you have taken a loan at 9 per cent per annum interest rate.
If you receive a windfall or a bulk amount, which can be used either to prepay a part or your entire loan, or invest this amount, you must first check the post-tax interest you can earn on any investment instrument at that point in time, which best suits your time horizon and risk appetite.
If the returns you get from the investment will be below the interest rate you pay on your loan, then it is better to part prepay the loan, in order to save on the interest cost.
On the other hand, if you can find an instrument which gives you post-tax returns of more than 9 per cent, then you should go ahead and invest the amount you have received, and not prepay the loan.
Say you have the risk appetite to invest in equity, and you wish to invest inequity mutual funds, which give you long term returns of 13
Then you will earn 13 per cent per annum instead of saving 9 per cent per annum on the loan.
This is the opportunity cost of money. If you choose to prepay the loan to save the 9 per cent interest, you will be losing your potential earning of 13 per cent per annum.
So you can build your wealth by investing any windfalls or surplus in higher earning instruments and at the same time fulfil your financial goals as well by taking a loan.
Another factor to be considered is the tax benefit enjoyed by certain types of loans.
If you take a loan which satisfies conditions laid down by the Income Tax Act, you can claim a deduction on your income.
This in turn reduces tax outflow and helps you build your wealth.
Home loans and education loans are two such loans.
In the case of a home loan on a self occupied property, you can claim upto Rs 100,000 on principal repayment during a year, under Sec 80C of the Income TaxAct.
In addition to this, you can claim interest paid upto Rs 150,000 in a year under Sec 24(b). You can claim unlimited amount on interest if it is a second home loan for your second house.
In the case of an education loan, the entire interest paid can be claimed as a deduction under Sec 80E of the Income Tax Act, if you take a loan from a recognised financial institution for a full time graduate or post-graduate course for yourself, your spouse or your children.
Notwithstanding the benefits of taking a loan and dealing with it wisely, you must always remember not to bite off more than you can chew.
This means you should never over-borrow or stretch your finances.
This can be checked by calculating a simple ratio -- the debt to income ratio.
This ratio explains the total outgoings in a month in the form of equated monthly instalments as a proportion to the total monthly income from reliable sources.
This ratio should ideally be less than 35 per cent-40 per cent.
So, do your math before you think of taking a loan.
In short, taking a loan can be a useful tool to build your wealth, provided you do not stretch your finances, know how to decide on prepayments and also have a contingency fund in place, to service EMIs in case of unforeseen events resulting in temporary loss in income.