Why taking on huge loans is not always a good idea ?

by Ashvini on January 17, 2011 · 8 comments

in General

Debt trap

One of my dearest friend Nicola Deiana , talks about relationship between money and happiness. In that post on his blog, he analyzes the pros and cons of having a house of your own. He points out some of the ratios that you need to know before you invest in a house.

Investing in the house or for any other instrument is a matter of understanding basic financial principles. Most of the times, one takes big loans and then get into a debt trap. Due to proliferation of banks and the easy flow of cross-border money, the supply of money is typically endless. Due to this, it is very easy to get a loan on your terms at extremely low interest rates.

However, the mortgage crisis that has severely impacted the United States and thus a large part of the world, makes us think that is it even possible for everyone to get rich. By taking a huge loan for purchasing a house, where per square feet rates are rapidly rising, we are putting ourselves at a risk. Let us see how?

Its just a question of semantics. Many people call house an asset. In accounting, asset has a clear cut definition, an assets is a device ( or instrument) that provides some benefit or can be converted to cash. While assets bring money into the company/ or personal finances by its use, liabilities call for an outflow of money.

Let us take an example, if you purchase a prime commercial/residential property at good rates and can get a great amount of rent that fits in formula mentioned by Nicola, you are making money on the asset. However if your loan amount that you pay monthly on the bank loan is greater than what rent brings in, your investment is eating away into your money and is thus a liability.

So the simple rule is

Am I( or will I) making( or will make) money on the investment that I am thinking of.

Investments should never be done for emotional reasons . If you like a house , purchase it because you liked it. Never purchase a house because it will appreciate 100 -200%. In case it does not you are saddled with a huge loan on your account.

While calculating the value of house you should add

1. Taxes,

2. Society membership costs,

3. Maintenance cost

4. Liquidation costs if you have to sell your house in emergency.

Add up the costs with the actual cost of house. Your house’s sell price should be more than all the costs added up. It is actually very convenient to avoid factoring in these costs but they are there , like it or not.

A good way to calculate what is the right value you should pay today is Discounted Cash Flow method. DCF helps you determine the right value of your house or any other financial investment by taking a target percentage return( which should be realistic).

The conclusion is that taking large loans is always a risky option and should be done with a lot of care and right calculations. Always write down those assumptions and make sure that you liquidate your investment without suffering losses.

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{ 7 comments }

Veronica Cervera November 15, 2011 at 5:05 pm

Having a home has indeed considered by many as an asset. In reality, a home is an expense. Acquiring a loan is an expense unless one will use it to invest and turn it into an income generating asset. The best way to approach this is to have some sort of income to pay off that housing loan. A lot of people went bankrupt just because of mortgage payments. What happens if one suddenly gets laid off from their job? It’s wise to have some sort of side income that would shoulder the payments.

Nicola Deiana February 1, 2011 at 5:21 am

First and foremost thanks for have mentioned my post on your article. I surely will return the favor. Second, I agree with you Ashvini, cautions is essential when you have to manage lots of money. I never had experienced with home loans, but If I would need one, I think that will make a comparison between homes with similar features and price, then finally will make my choose without make strange calculations.

Ashvini Kumar Saxena February 2, 2011 at 11:08 am

Thanks Nicola. I am happy that you liked the article. Have a great day

Alka January 30, 2011 at 5:25 pm

Very apt…One has to be more cautious in present times where remuneration has increased but so has work pressure..God forbid if one has to say adieu to the job for any reason then liquidity should be at hand to pay the loan or to survive for a year at least.

Ashvini Kumar Saxena January 31, 2011 at 11:30 am

That is perfectly right. I do not believe in taking loans which I cannot pay if I am out of the job. Anyway taking huge loan is a big risk always no matter what people believe

Aswani January 17, 2011 at 1:21 pm

Excellent Ashvini…very well written. Well, I am still not in a position to think about loans and related things but maybe later, I will have to go for the same. I will certainly follow all your guidelines as mentioned as I find them very honestly researched. Keep writing such useful articles…all the best !!

Ashvini Kumar Saxena January 17, 2011 at 2:24 pm

Hey Buddy ,
Thanks for your comment.

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