Good loan -bad loan – how to differentiate

Every now and then I meet people who tell me with a sense of pride that “I have never taken any loans and never will.”

And on the other side of the spectrum, there are people in IT industry who have taken such large loans (for buying a premium apartment) that the EMI load is creating tensions in home, now that most IT companies are slowly downsizing.

So here are my thoughts on taking loans.

Loan by itself is not a good or bad loan.

It becomes a good or bad loan based on:

1. Your ability to pay the EMI’s after taking the loans. A good loan is one where you can repay it without too much of liquidity issues. Your repayment capacity defines whether a loan is a good or a bad loan.

I have come across people who have taken large loans for buying a home and they are left with very less cash every month after the EMI payment –if the EMI’s are so large that it impacts your living expenses – then it is a bad loan.

2. What do you buy with the loan.

To get rich, we need to amass assets over time. Assets are things that appreciate over time and/or give you cash inflows.

If you are taking loans to amass assets – that is likely to be a good loan.

But if you take a loan to buy the latest iPhone 8X, it is most likely a bad loan as the iPhone is not an appreciating asset but a liability (liabilities are things that depreciate over time and do not give you any cash inflows).

Further, the asset that we buy should also be giving a better ROI than the interest rate of the loan.

So for example, you have taken a loan for 20 lacs @10% interest and bought a farm land – while buying you expected the farm land to appreciate at 15% per annum. But after two years you see that the farm land has appreciated at only 5% per annum- but you are still paying interest on the loan at 10% – this is now a bad loan even though farm land is an asset and is appreciating at 5%.

If you are working in US, you can get loans at low interest rates of around 2% – if you transfer this money into India and buy the same farm land which is appreciating at only 5% – then this is a good loan as the appreciation (5%) is more than the interest costs (2%)

So a good loan would be one that is used to buy assets that appreciate at a higher rate than the interest costs and you should have the repayment capacity.

I hope you get the framework.

It is OK to have good loans and it is best to avoid bad loans.