If you wish to purchase something and you do not have enough funds, the best option is to borrow money. When you borrow, you agree to pay it back with interest within a certain time period.
For example, if you wish to borrow ₹1,00,000, the lender will ask you to pay it back in a year with an additional charge of ₹10,000. Here, 1 year is the tenure, and 10 per cent is the interest. This is the simplest illustration of how a loan works.
There are two parties in this transaction
- The borrower—who requires the money
- The lender—who provides the money
The borrower receives the money from the lender, and the former agrees to pay it back as EMIs (Equated Monthly Instalments) to the latter.
In this transaction, both parties benefit, and it is a win-win agreement.
The borrower requires funds immediately and, in exchange, is ready to part with their future income.
The lender has surplus capital and is ready to give it away in exchange for assured future interest income, along with the original capital.
This is how a loan works, but there is one more important aspect. Is the loan a good one or a bad one?
Just like we have good cholesterol and bad cholesterol, loans can be good or bad.
It takes a doctor to tell you if the cholesterol is good or bad. Similarly, you need a financial doctor to analyse if the loans you have taken are good or bad.
What are good and bad loans?
When you take a loan to improve your income—it's a good loan. If the loan increases your expenses, it's a bad one.
You already know that assets generate income and liabilities create expenses. A loan can multiply that asset or liability creation through leverage; let us explore that in detail.
If a person buys a car for ₹20 lakh using a loan and uses it for their own use, it is certain to incur expenses. Whereas, if he loans the same car and rents it out as a taxi, he generates income from it.
Most people take loans to buy liabilities, and that's where the problems start. Their future income goes into funding those liabilities and the expenses it creates. For example, when you buy a car for personal use, a ₹20 lakh loan for 5 years at 10 per cent would cost you ₹42,494 every month as EMIs.
The same car, if it runs as a taxi and brings in just ₹35,000 a month in income, your net EMI burden falls to ₹42,494–₹35,000 = ₹7,494/month.
If you are a successful taxi operator, you could earn more than ₹50,000 a month and remove dependence on your primary income.
The loans that reduce dependency on your primary income source, or generate additional income for you, are good loans. A true business owner knows this secret and uses debt to leverage his revenue and profits.
For example, a business that produces 1000 breads a month generates a revenue of ₹100 and profits of ₹20 per bread. But this business has a small manufacturing unit, and to produce more bread, it has to take a loan of ₹10 lakhs at 10 per cent interest for 10 years. By doing so, the total production can be increased to 10,000 breads a month, revenue of ₹100 (same), and profits of ₹18 (after accounting for debt repayments). This manufacturing unit now makes a profit of 18 × 10000 = ₹1.8 lakh* versus ₹20,000 before, i.e., a leverage of 9x.
*The added bonus a business owner gets is the 100 per cent exemption of the interest paid on the net taxable amount.
Bad debt is highly dangerous; it eats away at your primary income and puts additional psychological stress. Debts that fund your lifestyle upgrades are mostly bad debt; the benefit lasts a few months, but the expenses a lifetime.
When you wish to show how successful you are and try to fit in with society, the debts you end up taking are mostly bad. These expenses may start increasing, and for some other reason, your income is impacted; then you are staring at a possible bankruptcy.
The other issue with bad debt is that it never allows you to create assets. The bad debt is so hungry that it eats away your income, depriving you of funds to build assets. The end result: you end up with just liabilities and no additional income to fund them.
The next time you buy stuff using borrowed money, take a moment to assess whether it's a good loan or a bad one. Stay away from bad loans as much as possible to secure your future.
The writer is a SEBI Registered Investment Adviser (INA000021757), SEBI Registered Research Analyst (INH000025045), and author of ‘How to join the top 1% options traders club’.
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The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.
