How the High Cost of Reckless Borrowing Can Derail Your Financial Plan

Compared to a few years ago, borrowing money has become far simpler thanks to advancements in technology and finance. Today, to avail of a loan, all it takes is a few phone taps and a quick online verification. Having said that, it is seen that individuals are getting allured by easy access to credit, which is the primary reason for the lack of financial discipline among young adults. This article explains how such reckless spending and lending habits can derail your financial health and financial planning.

Let's first understand what is the cost of borrowing;

The cost of borrowing is the interest and other fees and charges, such as processing fees, late payment fees, prepayment fees, foreclosure fees, etc., that the borrower has to pay during his/her repayment period. The high cost of borrowing is when the borrower pays a larger part of his/her earnings towards the loan repayment.

Many individuals rely on loans to finance their big and small purchases or to cover emergency expenses. It includes a range of situations, from buying a house, children's higher education, buying a smartphone, medical treatments, etc., to even managing their day-to-day expenses like grocery shopping, paying utility bills, and credit card bills payments, among others.

However, as you might already know, unsecured loans like personal loans, payday loans, and credit card loans are high-cost loans that come with high interest rates compared to secured loans. These loans, with their high interest rates and other fees, such as processing fees, late payment fees, etc., can significantly increase the cost of your loan, which makes you pay a lot more (in some cases more than double!) than the actual cost of the product/service.

While it is true that secured loans like home loans and education loans help you achieve your goals, which would otherwise be difficult to achieve, it is important to understand that even such essential loans or what they are often called as 'good loans' that are considered low-cost loans can accumulate a substantial amount of interest in the long term, if not planned well.

My cousin, Akshay, had taken out a personal loan of Rs 10 lakhs to cover the cost of his father's heart surgery. He opted for a 5-year loan tenure with a 13% interest rate, resulting in an EMI of Rs 22,753. Over the course of the loan tenure, Akshay will end up paying a total of Rs 13,65,184 towards the loan repayment, including interest charges of Rs 3,65,184. Although early repayment is a viable option to reduce interest expenses, the prepayment and/or foreclosure charges need to be considered as well.

Besides, since his fixed monthly expenses have gone up due to the personal loan EMI, Akshay had to temporarily pause the mutual fund SIPs he had started a few years back to accumulate the down payment required for his home loan. If he had bought a health insurance plan for his family and established a contingency fund, his financial goals would have been safeguarded from disruption.

Let's take an example of a 'good loan'. Recently, my friend Bhumi purchased an apartment in Pune without making any down payment. She opted for a 25-year home loan with an interest rate of 8.5% p.a., amounting to Rs 1 crore. Her monthly EMI amounts to a hefty Rs 80,523, which is a significant portion of her monthly income. By the end of her loan tenure, Bhumi will have paid a total of Rs 1,41,56,812 towards the interest component alone.

However, as previously discussed, even a good loan can have a negative impact on one's financial well-being if taken without careful planning. In Bhumi's case, a significant chunk of her earnings is allocated towards the home loan EMI, creating a substantial financial burden. If she had established a financial plan and saved enough funds for a down payment, her interest outgo would have been significantly lower, and the EMI could have been affordable.

With a 35% down payment and a 5-year reduction in the loan tenure, Bhumi could have saved a substantial amount of money on her home loan and become debt-free in 20 years. By making these changes, she would have paid Rs 70,38,042 towards interest, resulting in a total interest savings of Rs 71,18,770. Besides, her new EMI would be reduced to Rs 56,409.

As we saw in the above examples, the first and the most significant impact of the high cost of borrowing is the increased debt burden and financial stress. High interest rates and longer loan tenures can quickly add up debt, leading to an unmanageable financial burden. If such stressful conditions are not addressed timely, they can result in defaults on loan repayments, ultimately damaging your credit score and making it harder to borrow in the future.

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Additionally, high borrowing costs can eat into your savings and affect your ability to achieve your financial goals. For instance, high EMI payments towards a loan can prevent you from saving adequately for your retirement, children's education, or contingencies. This can lead to a vicious cycle of debt where you keep borrowing to meet your financial needs, thus derailing your long-term financial health.

The high cost of borrowing can have a huge impact on your financial planning. Since you pay a larger portion of your earnings towards loan repayments, it can be difficult to save for your other financial goals. This can further result in prioritising debt repayment over other important goals.

Hence, it is crucial to be mindful of the cost of borrowing and its impact on financial health and planning. Before you avail of a loan, it is necessary to carefully evaluate your financial needs and plan the repayment accordingly. It is advisable to assess your capability of loan repayments considering the loan tenure and interest rates and having a backup plan in case of any emergencies.

Furthermore, it makes sense to explore different sources of financing, such as personal loans, secured loans like a gold loan, loans against property, etc., or even borrowing from family and friends, to find the most cost-effective option. This can help you minimise the impact of the high cost of borrowing on your financial health and ensure that your financial planning remains on track.

With PersonalFN's SMART Fund Explorer, you can plan your long-term financial goals, such as retirement, buying a house, saving for your child's education, and many more. To use the SMART Fund Explorer, simply state your S.M.A.R.T financial goals. Determine the time frame for achieving these goals, and enter the amount required in today's terms, as well as the lumpsum and/or SIP investment you can afford to make. Then, simply tap on "Show Me My SMART Investment Plan". The tool will present you with tailored investment plans based on your financial goals and investment preferences.

As you scroll down, you will see two recommended mutual fund investment plans (Plan A and Plan B). These plans display the recommended fund categories to invest in, the suggested asset allocation percentage, estimated returns for each category, and the weighted annual return contribution. You can select a plan based on your personal risk tolerance.

To conclude:

The high cost of borrowing can significantly derail your financial health and financial planning. Hence, it is crucial to be mindful of the impact of borrowing on your long-term financial goals and plan your borrowings carefully. This will ensure that borrowing remains a tool for achieving your financial goals and not a burden that derails your financial planning.

KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.