The Rules Of Borrowing

The pandemic called COVID-19 may be waning, but the low interest rate regime that it spawned, coupled with “revenge buying” that ensued, have led to an increase in personal leverage for many of us. And while buying stuff can seem gratifying at first; they all too often result in the famed ‘buyers regret’ syndrome later. In fact, irresponsible borrowing can spell doom for your finances and sink you to rock bottom quicker than you would believe. Here are three rules you should make your own when it comes to borrowing.

Rule #1: Never, ever revolve credit card debt

Anybody who has ever fallen face first onto the hamster wheel of revolving credit card debt will surely testify to its extreme dangers. It’s absolutely vital to not revolve your credit card debt, and make sure you pay them off in time each month. Overborrowing can quickly spiral out of control, affecting your peace of mind and your credit score in the process, so be watchful at all times. Two things happen when you fall into the pernicious trap of revolving debt – one, you incur massive interest costs that could be as high as 40 per cent per annum (yes, you read that correctly!). Two, interest costs compound and accrue over time and sometimes lead to situations which are impossible to get out of without taking drastic measures like selling off a long-term investment or asset. 

Rule #2: Keep your Debt-to-Income Ratio < 20 per cent

You may well be tempted to over leverage yourself, especially if you’re the kind who is naturally optimistic about your future earning potential. However – you would be wise to keep your debt to income ratio (measured as your total monthly EMI’s, divided by your net monthly income) at less than 20 per cent at all times. For example – if your net take home salary is Rs 1 lakh per month, all your EMI’s combined (your car loans, personal loans and home loans) should not exceed Rs. 20,000 per month. Note that these do not include your small, short term, no cost EMI’s for purchases made on sites like Amazon, which you intend to pay off within 3 or 4 months.

Rule #3: Finance Assets, not Purchases

What does “borrow to create” mean? It means, it may make sense to borrow money if you’re using it to create a solid, long term asset. For instance, you many be taking up a home loan to buy a well-researched piece of property that you intend to hold on for a long time. Or, you may take up an SME loan to fund the expansion of an already flourishing and proven (keyword: not speculative) business that you own. These borrowings make sense, because the intention is to create a long term, appreciating asset from the borrowed funds. However, do not ever borrow (except on your credit cards, which are in effect a one-month interest free loan) to fund purchases- especially expensive ones that cost more than say, 1/3rd of your monthly take home income. Instead, save up in advance for them through recurring deposits or Mutual Fund SIP’s. You may end up delaying your gratification by doing this, but your finances will be a whole lot cleaner and healthier.