"Truth and non-violence are as old as the hills. I have nothing new to teach." -- Mahatma Gandhi, My Experiments with Truth.
While some of the basic principals of finance are as old and time tested, it is not always that you end up with an advisor like the Father of the Nation, who would concede that he has nothing new to say but to repeat the timeless classics.
It is worthwhile, however, to sometimes repeat to oneself some of the tenets of personal finance.
In light of the changed scenario on interest rates, let us understand the concept of leverage, or building assets on borrowed money.
Leverage, with due apologies to Marx, is the opium of the masses: it provides an instant high, though the next day, unfortunately, is not something to look forward to. The days of easy credit, say the experts, are over: you might have seen that in the rising interest that you pay on your home loans or personal loans.
However, when the going was good, it took little persuasion for anyone to try the shot at least once.
Easy credit, easy advice
It was easy to get carried away. You could borrow cheaply and invest in what you knew were assets that would appreciate in price. When you neighbour can do it, why not you? Was it not easy? All it required was to take a loan -- after all if the government promotes housing loans by giving you tax breaks, it could not be a bad thing for you!
Any property that you invested in seemed to have been touched by Midas: prices had only one way to go! With no worries on the price of your home, the trick was to try and see how much you could leverage. The larger the loan you took, the larger the property and the larger the gains.
Well, times change. The advice, which sounded so logical then, has come back to haunt your personal finances. In any case, for many people, the house they bought was for living and not as an investment: hence, any gains are purely notional.
In India, purchasing a house is treated as an investment. However, the correct way to look at the first house purchase is to look at it as a milestone. It is rare, if ever, that a person sells the only house that he has. What you are left with now is, hence, an illiquid asset but increased outflows.
There was help available too. "You want more loan, do you? Let me tell you some ways in which you can take a larger loan," said your advisor. "Go for a longer tenure, club incomes, count your perks as income, take a floating loan. In any case, once the prices rise in the next 2-3 years, you can sell, or if you wish to retain the house, you income will have risen to meet the stretched EMIs that you are agreeing to now."
The dark side
Let us look at the risks of the various strategies being advised a couple of years ago.
Go for longer tenure: If you go for a 20-year loan, the EMIs were lower than the 15-year loan, or the 10-year loan. While the pain of parting with money is spread over a longer period of time, since the quantum is reduced, it pinches less.
However, as interest rates rise and the bank tries to avoid pinching you harder, it further lengthens the tenure! This means that if you took a 20-yeara loan at the age of 28, you might be looking at a 30-year repayment now. This means that you will have to work your entire life -- to pay for this one house!
Club your income: Club your income with that of your spouse or parent and you will get a much higher loan. But consider now, that the spouse proceeds on maternity leave or decides to do something more closer to his/her heart which does not pay as much, or the parent has retired, the entire burden falls on you.
You -- and the bank -- considered that the steady state would be that all the co-applicants would be working and would be in a position to pay the EMI. The worst occurs when the decision to retire/have a kid/do something close to heart has to be postponed due to financial reasons!
Count your perks: Bonus or perks were considered as a right of the employee. This meant that even though you might work in an industry which has a high variable pay, you account for that as your regular income and request the bank give you the loan on the higher pay expectation.
Similarly, you might be receiving a non-monetary benefit, say a car from your company, which you include in your income. This means that while no cash flows to you, you increase the eligibility. Again, you are left with lesser cash flow today to meet your outflows.
Take a floating rate loan: You had seen rates coming down: it was hard to perceive that the banks were actually offloading risks -- it seemed more like they were putting you in control! By offering floating rate loans, the banks gave you a sense of power. You were not bound by one EMI through-out the tenure.
The risk of interest rate was to be borne by you: the bank would not bear your interest rate risk. In a falling interest rate environment, it looked more like a blessing: increasing interest rates are baring their teeth now!
What is the right way?
When you take a loan, always look at your ability to repay: never stretch beyond your limits. Always maintain a buffer for contingencies or unexpected turn-of-events.
When banks look at your eligibility, they look at it from only one angle: whether you will be able to repay them or not. Similarly, you should assess your situation. Banks typically look at the past -- or at best the present.
Depending on your current take-home and outstanding loans, the bank may decide the loan amount you are eligible for.
However, you need to take a forward-looking view: do you have a milestone coming up? Would that need some liquidation of your portfolio? Will all the applicants keep earning similar or higher amounts?
It is not very easy to time the market or accurately predict them. This is where historical averages are helpful. If the interest rates have dropped significantly from their long term averages, can you understand or explain the reason behind that?
Else, it would be a good idea to budget your EMI expectation based not on the current rates but more nearer to the long term rates. Consider the worst case income growth and interest rates 2% higher than what you took loan at and see to it you are likely to be able to service your loan even in that scenario.
Try to stick to a lower tenure loan, say 15-year tenure. In case things go wrong, you will have much more flexibility to get the tenure increased. If you play your card initially by taking the longest tenure loan, you will have to face the burden of a rising EMI later.
It is easier to comment on the 'truths' in hind-sight. When you talk to your financial advisor, see if he is going with the flow or does he understand the long term principles.
The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an alumnus of IIM-Ahmedabad and can be reached at info@parkfa.com.
