Frequent calls for personal loan or auto loan — saviour or loan shark in disguise? Keep these things in mind before you borrow

"They persuaded me to take a personal loan," he lamented online. Soon, readers filled up the thread with comments about how bankers and finance companies are sharks that prey on innocent people, luring and trapping them with high-cost loans. It is very tough for me to empathise in this case. So I just read the responses, trying to understand why someone feels privileged to receive a large sum of money to spend as one wishes. All loans, in all forms, are charges on future income that we undertake with full consent. Period.

There was a time when bankers and finance companies would focus on deposits. The incentives for staff were aligned with the ability to mobilise money. Lending was seen as risky and subject to many restrictions. Retail loans were unheard of and banks could not lend against immovable assets; no home loans on their books. The focus of lenders was to get deposits from the retail market and lend it to the corporate and institutional sector.

After this equation was modified in the 1990s in favour of the retail market, stocks of banking and financial businesses increased in value immensely. As incomes have risen for the common man, and the willingness to spend and borrow have moved up, lending to the retail market has become the bread and butter for the banking and financial sector. If there is an asset backing the loan, be it a house, securities or gold, so much the better. If not, a highcost personal loan can be taken against future income. Recovery remains risky, but margins are steep enough to make it a viable business.

The marketplace is now filled with lenders. If they see a possible stream of future cash flow, they readily productise it, and sellers are out to find borrowers. That does not make it evil, as online advisers suggest. It just calls for the borrower to learn, understand and decide on the basis of need and capability. A borrower who thinks a lender’s call makes the former the chosen one, he has already taken the bait.

The borrower is standing in a marketplace, where eager lenders are willing to take a risk on him. However, the math about the interest charged has been obscured by the EMI. No amount of education on effective interest rates and bifurcation of EMI into interest and principal has enabled the retail borrower to see what he is getting into. A very small percentage cares about and understands math. The lender takes the risk, the lender offers the money upfront and, therefore, the lender sets the terms. The borrower must make the effort to know what he is getting into. He can choose to be informed, educated and understand it. He has the power to say no, to choose from competing lenders, and to take the time to sign up.

Two things about the loan must be known to every borrower. One, the repayment will be much more than the borrowed amount because loans carry interest, reflecting the risk assumed. A zero-interest loan will come with other administrative costs and a possible marked-up price. There is no free lunch; it is a marketplace. Two, the interest will be recovered upfront, which means the initial EMIs will go towards interest, almost completely, tapering as time elapses. This also means that the principal repayment begins later, and prepaying the loan before maturity is costly. It is the lenders’ market all the way. Take it or leave it. Thankfully, it is a competitive market with many players.

What are the common mistakes that borrowers make? First, how much charge on the future income one can afford is a personal financial question that the borrower alone can answer. The lender can look at your assets or income and propose how much he will lend. Discount the number called ‘loan eligibility’ worked out by the borrower. Do your homework about how much you can pay every month. He knows nothing about how much you spend monthly, or the loans you propose to take, or other commitments. Even if the lender masks your eligibility as a privilege, it is not. You borrow, you repay. This simple first principle is forgotten by many desperate borrowers.

Second, using loans for large lifestyle expenses can create a lifestyle creep, which charges future income severely at the cost of savings and flexibility to make other large expenses. Upgrades to car, phone, home and holidays are desires that come with increase in income. Or not. There is a loan, an instalment plan, a deferred payment scheme sold along with these products. Keeping repayments within the capacity of future income is the only way to use loans. The underlying assets lose value quickly and loans are costly for this reason. The EMI masks this cost.

Third, if there is no asset to back the loan, not only is it expensive, but also risky for both the borrower and lender. Personal loans and credit card loans fall in this category. If you stretch your capability to borrow, you will find yourself in a debt trap, where you have a high-cost outstanding amount growing rapidly in value with time, snowballing into an amount you can ill-afford to pay from your regular income. Keep loans to the minimum and pay on priority before they balloon.

Is not borrowing at all a good policy? It’s a very conservative view. If there is a future stream of cash flow, converting it to an upfront lump sum that can get an asset to use right away, is a smart financial transaction. The business balance sheet uses borrowings as a lever to push itself to bigger size and efficiency. Banks and finance companies build on this leverage, borrowing as deposits and lending as loans to catapult the business upwards.

On a personal balance sheet, you have physical and financial assets that have value, and human asset that can generate income. How you leverage these to borrow and build more assets is a personal financial strategy. Many of us wouldn’t own homes if a home loan weren’t available. Our productivity with respect to work and small joys in everyday life are funded by EMIs. What we pay as EMIs can be saved to build assets too.

Borrowing hurts when the objective is to spend beyond one’s means, compromising tomorrow’s income today. Whatever be the temptation and sales talk, pledge your future income with great care. There are no free lunches in the lending market.

The Author IS CHAIRPERSON, CENTRE FOR INVESTMENT EDUCATION AND LEARNING