Credits to Credit

Having worked for much of my earlier work life on the investment/risk side of the finance, either as a research analyst or MF investment advisor or an Insurance guy, I was always a bit averse to the prospect of taking loans, no matter for what purpose. However, the past few years have completely changed the outlook of debt in the minds of young Indian consumers and I find it impossible to avoid delving on which aspects of debt justify the commitment to pay the interest out of your future income to pay for an asset/commodity today. Not all debt is bad. Sometimes it is just essential. My thoughts have been structured around classifying use cases for debt from an essential need to a credit-hungry expense while also adjudging the overall value it brings to the table

There are broadly 5 kinds of transactions that are catered by any sort of funding

1. Non-discretionary expense:
Probably the aptest case for taking any sort of loan is the need to fund non-discretionary expenses. These are non-avoidable expenses that crop up unexpectedly many times. Take emergency medical loans for example. Any household that runs a tight ship from one payday to another could experience havoc should a major medical emergency befall any of the household members. Worse, if it happens to an earning household member. While insurance policies are designed to address just these kinds of expenses, many times there are various peripheral expenses that need to be paid. A short term loan that eases off the cash flow stress is just the right kind of tool to address these situations (after checking off the most logical source, friends and family). Another such example could be a major wedding expense, accidental house fire etc, that puts a strain on immediate cashflows.

2. Income generation:
This is debt that is used to fund purchases/assets that are solely acquired to generate a stream of income. The thesis is simple — take debt at a cost of X% per year, and invest in assets that return more than X%. Sometimes this debt is primarily used to leverage the RoE on your investments (remember Dupont?). A typical example of such a loan is a working capital loan, which is used to stock up raw materials/inventory which can be used to produce finished goods that can be sold off at a higher price. Of course, the entrepreneur takes risks on business cycles, market demand, operational risks etc. But if executed well, this can be a very rewarding use of debt

3. Low depreciating/non-depreciating/appreciating asset purchase:
There is yet another use of debt that dominates the balance sheet of an individual. That is, the purchase of an asset, that need not necessarily be financially rewarding, but the ownership of the asset has a mix of tangible and intangible returns that makes it worth all the costs involved in financing using debt. In fact, many of these purchases are subsidized by the government and is a major factor behind the popularity of taking debt for these use cases instead of directly using equity mode of financing. Examples of such use cases are Home purchase (including land) and Education loans. One might want to argue that Education is more of an expense. I’d argue that while it's not a tangible asset, it’s definitely an intangible asset that directly increases the income-generating avenues for an individual, and elevates the intrinsic self-worth of an individual. One more thing. Some of these assets (home) can also be used for availing liquidity when required anytime in the future.

4. Depreciating asset purchase:
Things get a little tricky here. These kinds of purchase decisions are justified more by the intangible value derived from purchasing a depreciating asset, even though the financial sense of doing so may not seem outright prudent. Take a car for example. The moment you purchase a car, it loses 10–20% of its value on the road. In the first 4 years, the car is most likely to lose almost half of its purchase cost. Not only do you lose value on the purchase price, but you also lose any interest you would have earned otherwise had you invested that value. Add to that >10% rate of interest you end up paying to fund that purchase. While it would seem outright stupid to pay interest on an asset that is anyways going to put a hole in your pocket, it is still justified on three counts.

1. The cost of mobility that you would otherwise bear on alternate options
2. The lack of privacy and convenience in any other mode of public/rented transport
3. The sense of ownership — Yes, much like a home, there is a premium that is applied to owning a car. For many, buying a car is a highly emotional experience, overpowering every other consideration. Not to judge what is rational and what is not. It’s just a fact. It exists. Similar examples include a 2 wheeler purchase and even smartphones.
4. In short, many depreciating yet utilitarian goods that sometimes have an element of prestige attached to them.

5. Discretionary Expense:
This is where things get really murky. One of the hallmarks of a consumerist society is individuals making high-value expenses on loans. Why would they make such a financially imprudent decision you ask? Because what they want NOW isn’t what they can afford. And consumer loan companies are happy to give a helping hand to make you purchase things that quench the thirst for instant gratification that cannot be justified by any logical explanation. Let’s understand this with a popular example, international travel on loan. Be it media or Instagram, so much is the glamour behind ticking off an international travel list that individuals, mostly young professionals, are effectively trading off their future purchasing power to fund a week-long trip to Europe, Vietnam or Egypt. Sure, one would argue travelling unwinds you and adds to perspective. But is it really worth the cost? A 6 pack of beer would unwind you much more, and add a whole lot of perspective than travelling to Amsterdam on EMI for god's sake! Anyway, to each his own, and as long as there is demand from an audience willing to trade-off their future earnings for instant gratification today (which is an inherent human trait), the business model of most credit card companies and consumer finance NBFCs looks good. A few more examples include taking a loan for cosmetic surgeries, property rental, home renovation (although one can argue this to be better suited to bucket 4 above), etc

In brief, any funded use-case can be plotted along two axes (there’s always two axes, right?).
Emotional vs Logical
Discretionary vs Non-discretionary

Here’s a very subjective plot of where each of these use cases would fall on these two axes.

Hope this helps defined a framework for evaluating your next funded (debt) purchase/investment.

Originally published at http://kushalkothari.wordpress.com on March 4, 2020.