Does your loan fulfil the AA criteria?

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I was catching up with Arihant, an ex-colleague and an IIT-IIM (Indian Institute of Technology-Indian Institute of Management) graduate, who now runs a successful company. He described his first brush with financial leverage in the early 2000s when he had just begun working. Despite earning a good salary, Arihant’s lifestyle expenses surpassed his earnings. He soon ran up a credit card bill amounting to three months’ salary. He had to seek financial assistance from his parents to clear off this debt. After this experience, Arihant curtailed his expenses and soon repaid his parents.

Arihant’s story illustrates human beings’ evolutionary bias for instant gratification. When our ancestors lived in the jungle, they gratefully consumed any meat that was lying around. That makes humans different from hibernating animals who have an instinct to hoard food for at least a season.

With the advent of civilisation, laws were enacted. Lenders who provide resources for instant gratification can enforce contracts and recover the resources (mostly money) with interest, underscoring the need for prudent borrowing.

Borrowing entails pledging future income to pay for today’s gratification. It is not always bad. A good loan contributes to asset acquisition, like the purchase of a house, or enhances earning potential, as happens with a business or an education loan.  

A good loan must fulfil the AA (double-A) criteria: it should ‘add’ to assets or income and should be ‘appropriate’. Appropriateness is best judged by the percentage of future income pre-empted for paying back the loan. If all repayments amount to around one-third of income, that is considered fine.

A home loan (which adds to assets) that passes the appropriateness test can be considered a good loan. A vehicle loan does not add to assets but enables one to earn an income. It may be considered a good loan (given the abysmal state of public transportation in most cities) provided it passes the appropriateness test.  

Experts suggest reading the fine print before signing a loan agreement. My extensive experience tells me most people would not sign an agreement after reading it, given their one-sided nature (despite which the lenders have trouble recovering their loans from some borrowers).

Here are my suggestions for ensuring a fair deal. One, take a floating rate loan as Reserve Bank of India (RBI) regulations allow them to be prepaid or shifted without incurring any prepayment charges. Two, borrow from a bank and not a Non-Banking Financial Company (NBFC) as the former are subject to tighter regulations by the RBI. And three, take a secured loan. The very act of security creation causes the borrower to pause and rethink and does not provide the same pleasure psychologically as instant gratification until the loan is fully paid off and the secured asset is released.

The prevailing sentiment suggests that the indiscriminate use of easy loans by today’s youth may end badly both for them and for lenders. My view is that India’s younger generation is wiser than its preceding generations. A vast majority of them use loans sensibly, and the others, like my friend Arihant, will get back to the path of prudence soon.

Truth be told, loans serve as the lubricant that propels the wheels of civilisation forward faster. The home loan sector’s growth over the past five decades has demonstrated the transformative impact that responsible borrowing can have on a nation’s progress. Homeownership fosters a powerful sense of stability and social cohesiveness. Most home loan borrowers have ste­ady incomes and are less likely to go out and riot on the streets for any cause. Nevertheless, as with any powerful instrument, loans can create havoc and de­stroy lives if used indiscriminately and for the wrong ends (think of the 2008 crisis in the US). I am confident that the innate good sense that Indians possess in plenty will steer them (and the nation) towards a positive outcome.

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; X (formerly Twitter): @harshroongta

Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of or the Business Standard newspaper

Mandatory disclosure by SEBI

(A slightly different version of this column first appeared in the Business Standard on February 26, 2024)

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