Today let's talk about one of finance's most feared and mis-understood concepts.
Debt forms the back-bone of any economy. It is inescapable. No matter how rich you are or become, in some or other strand of your mortal existence, you would be compelled to deal with it.
Either when you use a credit card, go abroad for higher studies, buy a house, or decide to scale up your company.
Debt is modern society’s engine of growth.
Let back-track for a moment.
How does Debt work? What does it look like? Why does it transpire in the first place? If unchecked, how can it go so wrong?
The concept is straightforward.
Say you want to buy a car selling at Rs 10L. But you don’t wish to pay the entire amount in lumpsum. After all, Rs 10L is a sizeable amount. When you mention your concern to the car salesman, he promptly gives you an alternate. Instead of asking for Rs 10L upfront, he says why don’t you just pay Rs 1L (i.e. only 10% of the car’s selling price) and agree for a payment plan amounting to Rs 18,000 per month…and the car is all yours!
Not bad huh?!
Think about what just happened. For Rs 1L only, and a small monthly pay-out, your favourite Rs 10L car is yours to take home!
Let us assume you agree to this option. Well, congratulations!
For two things:
Firstly: For your new vehicle.
And Second: You just took some Debt (here known as a “car loan”).
Yes. The alternate presented by the car salesman included a mysterious third party i.e. a bank or a financing company, which in effect paid a major share of the lumpsum amount (i.e. Rs 9L) to the car showroom on your behalf. With the remainder Rs 1L coming from you (remember?), the car showroom makes its money on day one, as it would have liked.
The Rs 18,000 per month that you would now shell out, say for the next seven years, would go to the same third party (from whom you effectively “borrowed”) to repay the Rs 9L plus...surprise - surprise...Interest!
The car showroom makes its money upfront. The third party makes its money over next seven years by charging Interest. You get to buy your car, right now.
So, remember, when you “borrow” money…you take Debt.
Why is Debt so Attractive?
Well for starters, it allows you to spend more than your present capability. It allows you to invest and grow. It allows you to consume more. It lets you take home a car by only paying a small part of its total value upfront.
Why is it so Risky?
The fact that you have borrowed money, implies that you need to pay it back. And in most cases, you need to pay back with Interest. And if you don’t pay your dues, you’ll be in trouble.
What Kind of Trouble?
Let us get back to our car example. It has now been almost five months since you bought the car. You’ve made five payments of Rs 18,000 each, all on time. But in the sixth month…say your company starts downsizing…and unfortunately you end up losing your job. You don’t have an income and now the Rs 18,000 per month hurts.
A month passes by…you are unable to find a new job…and end up missing a due payment.
Someone from the bank calls and gives you a stern warning. You’re hopeful that you’ll get back on your feet soon, so end up dishing another Rs 18,000 from your savings, but the bank levies a small penalty this time for the delayed payment.
Another month passes by…you still don’t have a job…and you start panicking. You call the bank and tell them you’re unable to pay them anymore. Your bank account is almost empty. You don’t have any savings. The bank sends a guy who takes away (or “reposes”) your beloved car.
Another month passes by, and amidst all these distractions, you somehow manage to snag a new job. The pay cheques are back, and you are once again at ease. You thank your Stars…thinking the worst is over!
But is it? You now wish to apply for a credit card. The credit card company rejects you. Your health insurance policy is up for renewal, and your premium spikes up. You try to take another car loan, and the Interest on the monthly payment this time is much higher than Rs 18,000 like last time!
Simple. For the banking system – you are now deemed as a risky borrower. Your erstwhile “default” on the car loan turned your good debt into bad. Anytime you need to borrow in the future, the system would remind you of your risky behaviour, either through rejection, or through a higher Interest rate.
This distinction between good debt and bad debt is important. Good debt can easily turn into bad without proper planning or due to unforeseen circumstances.
Debt can do wonders and grant you 'leverage' but chasing too much leverage comes with its own set of risks, costs of which can be far-reaching and far too real.
Debt is a tool that works best when used carefully.
Scratch that, Debt is a tool that ONLY works when used carefully.
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