Bank loans and EMIs may not be the correct way to build assets

Shravan Sharma is 35 years old with two children and a wife, who is a homemaker. He is currently paying EMIs for his car, home and personal loans. However, he is not too worried because he earns a good salary and is confident of being gainfully employed given his professional qualification. He thinks that the funding from banks is a good way to increase his asset base. He also believes that EMIs result in compulsory savings and that he may not do so if he did not have a loan. What precautions should Sharma take given his penchant for loans?

To begin with, Shravan Sharma needs to understand that his portfolio may run the risk of being too skewed, with a high proportion in property. If a large chunk of the income is used to pay the EMIs for a home loan, he will be left with little to build any other asset and might be compromising his need for liquidity. He should ensure that at least 30% of his investments are in other assets that are liquid, easy to access, and flexible. He should build them as a priority.

Second, Sharma runs the risk of default if his EMIs comprise more than 50% of his income. In a household with young children, the mandatory needs are likely to go up as the fees for private schools, coaching, extra-curricular activities, cost of outings and travel are likely to increase. Sharma should enhance his savings to provide for these needs, and to do so, he needs a higher monthly surplus. The existing EMIs will hurt this objective.

Third, loans will always have come for a higher cost than the return from the assets, except in the case of property, which may appreciate at a higher rate. However, a self-occupied home is not an earning asset, while those like a car depreciate in value. Therefore, Sharma's logic about using loans to build assets may be flawed. He may be substituting his inability to save regularly with costly loans, which reduce his wealth and flexibility to build assets.

The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre and Arti Bhargava.