Acquiring your favorite assets through a loan is probably the one of the most easiest way to fulfill your materialistic needs and wants. However, it is also one of the most easiest ways to become a pauper as well. If you don’t keep an eye on how many loans you accumulate, it will be a matter of time before your financial planning goes awry. Let us see how many loans can I apply for ?
First things first, investors need to differentiate between good loans and bad loans. Good loans are those that help you build assets over a period of time. They contribute in increasing your personal net worth. For example, if you take a loan to purchase a house you want to live in, then that qualifies as a productive or good loan.
What’s a bad loan then ? A loan that is used to fund a depreciating asset, though this is not the case always. For example, a bad loan is a loan on a car purchase or a loan on a phone purchase.
Loans as percentage of salary
Any loan you take, remember that you need to pay up each month in EMIs (Equated Monthly Installments). EMI is nothing but the amount of principal and interest you pay each month to the lending institution from which you have taken out a loan or mortgage. EMIs are generally funded through the salary you get each month.
It’s a no brainer that the more EMI you have, the less money you will have left for expenses in your daily living. But wait ! You also want to save and invest each month, right ? So that means that you should have enough money left to pay for your expenses and investments.
A general rule of thumb is :
- a minimum investment of 25% of net take home salary is mandatory
- a maximum expense of 35% of net take home salary is acceptable
- total loans of 40% of net take home salary is ideal
If you look closely at the above combination, you will realize that if any of the above three increases, the money left for the other two will decrease. So if the EMI increases, money left for expenses and investments will be reduced.
Most small time investors who take loans on floating rates of interest suffer because of this. When the interest rate rises, the EMI increases and sometimes even inches as close to 50% of net take home. That is dangerous – simply because most of the investors cannot control the spending they do and hence the money left for investments is reduced.
That’s not good for your goal based investing strategy as you will now not be able to meet your future goals as you are saving less because of larger EMIs that you are paying.
So make sure that the total EMIs that you pay in a month is not more than 40% – 45% of your net take home.
How many loans ?
In a worst case scenario, you can land up with a home loan, a car loan, a credit card debt, a personal loan or maybe multiples of these. How do you remove this clutter of so many loans in your portfolio ?
Follow these steps :
- First identify your loan as a good loan or a bad loan.
- If the loan is good, do nothing.
- If the loan is bad, choose the bad loans which you can possibly close out. You will not be able to close out all bad loans – eg, a car loan.
- From the above list of loans that you can close, sort out the ones which have the highest interest rates.
- Close these down and move into ones with the lowest interest rates.
Steps 3, 4 and 5 are nothing but an attempt to close down those loans on which you are paying the highest interest rate. Note that a loan with the highest interest rate will not necessarily have the highest EMI so make sure you go by the interest rates when you make the decision.
Less number of loans is less paperwork, less tracking of when the EMI will be debited from your account and less follow ups.
Finance is simple. Keep the underlying basics simple as well.
My take
I think the small investor should have only two loans. That is the home loan and the car loan. I say that because both of these have become a necessity today and the small investor does not have all the money for acquiring these assets with full down payment. If you have an education loan, then that is acceptable as well with the assumption that the money you pumped in for education will fetch you a better job (read higher salary) in the future.
So if you are saddled with a personal loan or a credit card loan, you need to take a serious look at how your finances are geared. and whether you planned on having them in the first place. My advice would be to get rid of such loans. These loans never did anyone any good, except the lending institutions.
How many loans do you have and how much percentage of your salary is that ?
RaviShankarKota says
Very nice article on loans.I believe you are the first to cover this topic so comprehensively.Thanks Radhey.