Make Smart Borrowing Decisions: How to use Credit Judiciously

There was a time when taking loans was looked down upon. Bollywood films from the 60s & 70s all showed families under monstrous ‘Karza’ and facing hardship and exploitation in returning the money ‘sood samet’ (interest included). The doom was brought upon people by dubious lending since there was hardly ever any concept of a good loan. This is when our entire economy, since time immemorial, has shown how societies functioned perfectly fine in this ‘lain- dain’ system of give and take.

One finds ample reference to money-lending activities in ancient Indian texts. Our Vedas have terms like Kusida, Vardhusa, Vridhi and Vyaja, that refer to interests. Kautilya’s Arthashastra talks about different forms of loan deeds such as Rnapatra, Rnapanna, or Rnalekhaya.

However, it was only after the government started liberalising the economy and the banking sector that we started seeing loans in a different way. Not everyone is born into money and affordability but every one is allowed to aspire for better lives. And loans became the legit ticket for a good, more progressive life.

It is also important to recognise that a country’s economy flourishes if its citizens have the purchasing power and invest money in growing the economy. Loans enable money movement and supply in an economy and create a corpus for capital investments, enabling new technologies, pushing growth. Even governments and countries borrow, and loans therefore are not seen as evil today.

Modern credit systems have ensured that you don’t have to visit someone to get a loan sanctioned. The processes are fast and smooth, loans can be applied digitally via internet banking, no massive paper work, banks make it lucrative for their customers to take loans with flexible terms. And so, taking loans has become very common. But if one doesn’t recognise a good loan from a bad loan a debt trap is inevitable. So, let’s see how we can make the best use of loans.

Most of us are already using credit cards. That is the simplest explanation for borrowing. We sometimes overdraw in our bank accounts, which is also borrowing of sorts. But if we were to define borrowing then it is the activity of borrowing money from people, banks or organisations for your use and paying it back with interest - periodically in instalments or after a given fixed tenure.

When it comes to organised loans given by banks and organisations your credit profile and credit ratings play an important role in ascertaining how much loan can be serviced by you in the long term. Lending institutions have built systems to assess the risk that comes with lending to people that don't have the current wherewithal to pay off the loan. This automatically works both for the lender and the borrowers as due diligence is followed in finding the risk appetite and an expert is always available to offer insights.

However, in the disorganised sector loans tend to become liabilities. India is rife with the unorganised credit sector; therefore, we need to be careful and smart while picking loans. People download private loan apps which make this unorganised lending sector appear very professional however there are several layers to the transactions and hidden costs. People make the mistake of not reading the fine prints and then end up in messy, murky situations with debt collectors at their doorsteps. One really needs to separate good from the bad, safe from the unsafe. This is why, some of these apps are called the LOAN SHARKS.

Credit should be used to make life easier and more convenient for us (credit cards). Credit should be used to build safety and security for our families (home loans) or to improve long-term success rates (education loans) or to save us time and costs (vehicle loans). If we use credit as a tool, judiciously only when important, it will also help us get smart about improving our credit scores along the way, allowing us access to bigger capital at lower rates over a longer period.

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Loans can be classified into secured or unsecured. When one is required to pledge a collateral as security for the money borrowed it is a secured loan and can be seen as loan against property, against insurance policies, against fixed deposits and gold also. Unsecured loans do not require collaterals to be pledged and cover personal loans, education loans, motor loans or short-term business loans.

A few things to always keep in mind when it comes to taking credit –

Your monthly instalments for all your loans put together should not be more than 50% of your monthly income.

1. Low-interest rates are better than high-interest rates

2. Low-tenure payback cycles are better than high-tenure payback cycles

3. Have the option to close your loan through prepayment (that is, pay off all the balance principal at one go, with no interest, and close the loan)

4. Be timely in paying our instalments, as that also affects your credit score.

5. If you ever 'settle' an existing loan/credit on your name without paying off your full dues, it will adversely impact your credit scores, and it might take your credit score years to recover from that blow.

6. There are free tools that let you check your credit scores, and you use them regularly (not more often than once a month) to see how you are progressing.

7. Take insurance coverage for big loans to protect your family from debt burden if something happens to you.

8. Don't borrow to invest in shares. This would mean a guaranteed interest that you will have to pay along with returning the principal, based on expected return on a non-guaranteed and  volatile asset class. Things can drastically go wrong if your expected return does not materialise or worse, you go into a loss. So always think twice before borrowing to invest in shares.

9. Don't give into IPO mania and apply for all the IPOs that come up. Do your research and invest smartly.

Loans are not bad. In fact, credit can be used to build on one’s investments. For example– you have been ">saving money and now you have 7 Lakhs which happens to be the same as the cost of the car that you have been wanting to buy.  Instead of spending your entire savings on buying the car, a smart way to go about it would be to make a downpayment of 20% of the total amount, and take a loan against your income. That way, you can spread out your expenses for the car over a period of time, and make use of the remaining 80% for investments and unforeseen expenses; which will ensure a safer approach and a better rate of return over time.

Disclaimer: Reach out to your financial advisor for a better understanding of your risk management needs and investment tools.

The article is published in collaboration with BSE Investors’ Protection Fund to spread awareness with respect to personal finance and investing, especially for women.