When is it better for individuals to take a loan?

Should one take a loan to buy assets or use cash reserves? This is a typical personal finance dilemma.

Cost of debt is less than the cost of equity (normally), that is why companies use leverage to grow their business. [The cost of debt is the interest a company or an individual pays on its loan. Cost of equity is the return a company or an individual requires for an equity investment.]

However, we have also seen that in the pandemic era, companies with lesser debt are being preferred by investors and also expected to do well compared to high leverage companies. Top corporates like Reliance Industries have become net debt-free, Tata Motors plans to be debt-free in three years.

During the pandemic, many people lost jobs or had their salaries / incomes slashed. People who were debt free enjoyed peace of mind while those with debt had to opt for moratorium and / or go for resolution.

There is no one fits all approach. As a thumb rule one should not take loan for an asset which depreciates like a vehicle. On the other hand, loans can be considered for assets which appreciate like a house.

The decision whether or not to take a loan should be based on the following criteria :

  1. Existing own fund is earning a higher rate of return than the rate charged by the loan provider to fund the purchase of the asset
  2. If the benefit is likely to accrue in the foreseeable future, then the Internal Rate of Return (IRR) of the asset is greater than the rate charged by the loan provider to fund the purchase.
  3. The loan taken is for an emergency cause and of extremely short tenure (less than 1/3 months) and the annualised interest rate is equal to savings bank rate

In either of the scenarios the fundamental assumption is that the borrower will have sufficient cash flow or earnings going forward to service the loan (both interest and principal). 

The reasons why it is important to honour the debt obligations / servicing are :

  1. To ensure that the underlying assets do not get seized by the lender
  2. To avoid downward revision of the individual’s credit score. A lower credit score inhibits future borrowing ability and even if one secures a loan its terms (interest, tenor, security, covenants) would be adverse

We enumerate 3 scenarios under which a loan can be taken / not taken. An individual could use these examples to evaluate other assets before taking the decision.https://embed.fireplace.yahoo.com/embed/ab9f4060-7d27-4fa1-89ec-8cf567b8aab4?articleId=3545e8ec-7d48-3d39-bb3c-9a8b20301707&ctrl=PollListview&m_id=polls&x_ap_enrich=.html

Housing Loan 

If one is planning to buy a house for staying (not for investment) then this is probably the best time especially through a housing loan. While there are enough analysis and statements to the contrary, we believe the following reasons are good enough:

  1. Property prices are attractive and if an individual is a serious buyer then the developer could offer him a good discount.
  2. Interest rates are amongst the lowest in decades and real interest rate (interest rates less inflation) is close to zero.
  3. After incorporating tax benefits (principal Rs. 2 lakh per annum / interest Rs. 1.5 lakh per annum), the effective cost of buying a house is lower compared to even returns in fixed income instruments / debt products.

Even otherwise, due to the real interest rates being lower than housing asset inflation rates, buying a house through a loan enables wealth creation. It is also a separate asset class in terms of financial planning and also provides a sense of security in terms of crisis.

Vehicle Loan

This is one loan an individual can avoid, if he has a choice. The key reasons for the same are :

  1. Vehicle is a depreciating asset. At the end of 5 year or 7 years of loan tenure, its value is 20%-30% of original cost unlike a house 
  2. There is no tax exemption on the interest or the principal amount.
  3. The interest rates tend to be higher than the housing loan. So the risk / reward of investing borrowed money gets narrower as the difference between cost of debt and cost of equity is very less. Thus an individual has to take extra risk to deliver more returns on his existing cash reserves to offset the interest costs.
  4. There is no wealth creation.

Loan for ESOPs

Employee Stock Option Plans (ESOPs) are shares issued by a listed company / start ups to its employees. The share price for such issues are pre-determined and tend to provide the employee a long time (1-3 years) to exercise this option. While the employee has to pay tax on such shares (Fringe Benefit Tax) but its applicable only if the issue price is lower than the market price.

Here too, an employee should subscribe to those shares whose issued price (also known as exercise price) is lower than the price of acquisition.

Price of acquisition is the sum of :

  1. Issue / Exercise price – Price at which it is being issued by the company
  2. Fringe Benefit Tax  – ( Market Price – Issue Price ) x Tax slab rate of the employee (10%, 20% or 30%)
  3. Interest costs of funding the acquisition
  4. STCG – 15% on the capital gains

Exercising ESOPs through loans has the following advantages :

  1. Enables wealth creation – Since the ESOP is exercised when the market price is higher (also known as “in the money” and factoring all other costs the individual is still at a profit, then he / she has created wealth without investing a single rupee.
  2. Inculcates financial discipline – The entire process of taking a loan for exercising ESOPs educates the individuals of the different scenarios that could emerge from the time of getting the loan to the time of selling the shares. This wealth of knowledge enhances the individual’s understanding of risks, reward, leverage, compounding, taxation and businesses valuation.

Key caveats to the strategy of taking a loan versus using cash reserves to buy an asset:

  1. An individual is expected to keep a backup plan if the underlying asset is not appreciating and / or the servicing of loan becomes difficult
  2. If the cash flow turns or is likely to turn negative for a reasonable period of time then it is better to sell the asset and repay the loan as the additional costs could negate the present value of future gains.

This Article has been originally published here

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