Debt / Personal Finance

Guide to Financial Independence – Managing Debt

We all know the old saying “No Pain, No Gain”. That was obviously before borrowing became a way of life! We gain first and then pay the price of delayed financial independence. Debt makes living life much easier. So why not borrow?

In an ideal world all of us would be able to control our desires and be born financially independent. We would have enough money to service our needs and be happy.  In reality though, many of us end up needing to borrow, even though there is never a good time to be in debt. It is a drain on our savings and postpones our financial independence.

Can debt be useful?

Debt is one way to increase your affordability without any immediate pain. Even so it does not mean you borrow to meet every need and desire. Borrowing for any discretionary spending or just a desire is a strict no. Want to visit Europe on vacation, but do not have money? Do not borrow, save up first! Want to buy the latest curved TV from Samsung, but do not have money? Do not convert into EMI, save up first!

When can you borrow:

Debt - Power & Responsibility
With great power comes great responsibility

Lenders are making it easier and easier to borrow. You have the power to sometimes borrow beyond your means. With great power comes great responsibility. Borrow only when really necessary and it is a question of true happiness. The only scenarios where I personally feel that borrowing is justified are

  1. Buying your first home – When you look at this objectively it is very clear that buying a house in India is not financially prudent in the current scenario. Prices have been either dropping or growing at very low rates. Most importantly though, since prices are at already astronomic levels that renting is much cheaper. That being said, buying your first home is an emotional decision. Especially in Indian context where this is part of our psyche!
  2. Education – I personally consider education as an investment and extremely important. As a parent, your retirement plan should take priority over your children’s education. In cases where your fund will not cover both, an education loan is advisable.
  3. Emergencies – There are options to mitigate this risk. Build your emergency fund. But in cases where you the emergency fund is not enough and your investment are not liquid enough, you have to borrow.

In the first case, you will have enough time to shop around and get the best deal for you. In the second case, it is better to keep yourself appraised of your emergency plan. How much will you be able to manage by yourself? What are the best ways to borrow money in a hurry? Which are the cheapest? And start an emergency fund today if you do not have one already.

Understand the true cost of debt!

Today, we are bombarded from all directions with advertisements on all the options to borrow money – home loans, vehicle loans, personal loans and even converting purchases into EMIs. All of these come at a cost to us and it is important to understand this before we chose to borrow. Ideally we should give equal consideration to both EMI and loan tenure. But in reality, we decide the the loan amount based on the approval limit and EMI from the lender. We accept the longest tenure possible just to ensure the EMI is within budget. This is ok, if we are aware of the extra cost and are ok to sacrifice some other part of our financial plan to bear this cost.

Interest vs PrincipalInterest considered as 9%

What this graph illustrates is that for any increase in tenure you end up paying a lot more interest. Money that you could have invested and that would have compounded and built wealth for you! The interest paid more than doubles when the tenure increases from 10 to 20 years. At 20 years you pay more than the principal as interest. Wow! No wonder the lenders are bombing us with ads and making borrowing easier. 

The point here is that a lower EMI does not mean you pay lesser interest. In fact it means you pay MORE! Now, we move on to the most important question

How to define a genuinely affordable EMI?

Now that we understand that EMI should not be the only driving force behind the debt plan, lets see if there are some easy rules that can help us. There is just one rule to remember. Ensure your total EMIs for the month – inclusive of all types of debts – is less than 25% of your monthly gross income. This is for the prudent financial disciple. In my view, this should be our Lakshmana Rekha

. Of course, this being personal finance, you will have to define your own limits.

Now that you know your EMI, try out various tenures to see the total loan amount that you can avail. (My personal limit for tenure is 10 years.) The amount required to invest in home/education minus this calculated loan amount is the required down payment. If you do not have enough to finance this down payment, you will have to save more and wait. Or take a hit on your investment plan for the foreseeable future.

Tax Implication: Saving on tax is considered as one big saving on home loans. The reality is that you do not save money. Instead of paying the taxman you pay the lender. It just means that your rate of interest is reduced depending on your tax slab.

Example: If you are in the 20% tax bracket your interest is reduced to the rate of 20%. If you loan is at an interest rate of 10%, the effective rate becomes 8% for annual interest payment upto 2lakh INR. This effective rate is what you will need to consider in your EMI calculation method detailed above.

Paying off Debt

I have personally borrowed just once. During my 2nd year out of college, I used up my savings from salary + a loan to buy myself a Honda Unicorn. This was way back in 2005 and I had no idea about loans. I just took the first option offered since the EMI was well within my affordable range. Ignorance is truely bliss! I was well and truely over the moon to own my first vehicle and enjoyed it immensely until I sold it when I moved out of India in 2011. We do not own a home, and so did not need to borrow to buy one and our car was paid up completely. So if you are someone who needs expert advice on how to manage debt, apologies. I am not the right person to advice you.

What I can share though is one tried and tested method shared by Ramit Sethi. The snowball method that Ramit Sethi has defined should help you get off to a running start.

Also make sure you look around periodically to see if you can get a better deal

  1. A lower rate of interest – more benefit when you switch to a lower rate earlier since the interest component in EMI is very low in the later stages
  2. Flexibility and charges on pre-payment

There might be other reasons too. Do a quick look at one of the websites that offer comparisons to ensure you do not lose out.

Invest or Pay off Debt: This is a tricky question similar to rent vs buy. Financially, the decision is very easy. Chose the option that has the bigger pay off. If the interest on debt is higher than the ROI on investment, pay off debt. If it is the other way around, invest. On the other hand, I personally would like to not have the hassle of monitoring debt. I would prefer paying off debt first.

Our Plan to Manage Debt

As I have mentioned earlier in this post, we did not borrow to buy our car. We almost borrowed to buy a home before we decided that pursuing FI/RE was more important to us. So we deferred that home purchase to a day after early retirement. You can read about that here. Even then, we do not want to borrow. Our budget will be constrained on the money we will have at that point in time. Hopefully we would have saved enough by then to buy ourselves a comfortable home.

We already have an emergency fund that should cover everything except the most extreme scenarios. Our investment plan is well underway and is on track as on date. We need to ensure we stick to this plan and augment it with bonus/incentives that we receive annually. As long as we stick to our current savings rate and income growth, we should have enough for us to live a comfortable life after retirement. The only couple of items that worry me are rate of increase of cost of health and education. Health can still be covered with proper insurance, but an education for our children loan is something I am still open to look at.

Have you borrowed or are planning to borrow? What was/is the driving factor behind your decision? How are you planning to manage your current debts?

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4 Comments

  1. It has worked out for us we were lucky to experience a boom in our local market. We would not have been in the position we are today if we had not taken some risk and used a bit of leverage. I think used responsibly it can be an okay move. You can get ahead without using it as well it is just a longer road.

    1. Good for you! Happy it worked out for you. I personally am not looking to own a home or a rental property here in India. The rental incomes are abysmal. The only reason real estate should be considered here in India is for capital appreciation. Not for me. I will buy a home to stay in when we retire though.

  2. I had to borrow to get an education. I paid those loans off and now only carry a mortgage. A mortgage doesn’t bother me however I think people can use debt in negative ways and really set themselves back.

    1. Hi DM,
      Welcome to FS. Sometimes we make mistakes and sometimes we borrow out of necessity. Education and Mortage are 2 situations where debt can be considered as an investment. At the very least I believe they satisfy our basic needs. Very unlike buying a TV on EMI. The Mrs. & I have been fortunate enough to not need to borrow for education. It was also easy to decide not to start a mortgage since rents are very low compared to EMIs in Mumbai. It is really great to hear you have paid off the education loan. And I believe mortgage EMIs are lower than rent in most US/European cities. So a mortgage might actually be beneficial as long as cash flow is good.

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