“The choice Rina” - Financing with Loans

Written By– Vibhav Bhat and Yash Bhave

PGDM Finance - TAPMI, Manipal

During World War 2 when allied planes were being shot down at an alarming rate a decision was made to add armor to the planes. But the problem was adding armor to the entire plane would increase its weight beyond its capacity to fly. Hence a decision was made to add armor to specific sections of the plane to maintain its ability and at the same time secure it. Similar to this, in life we cannot do everything with borrowings which will cripple you. A strategic choice has to be made to identify the areas which would benefit by financing from loans. But how to identify this? How is borrowing justified in some cases and not in others?

Loans and India

Loans are not a new concept in India. Loan, also described as “Rina”, can be found coined in multiple ancient economic and financial scriptures of India including Manu Smriti and Arthashastra. They have specified rules for lending and borrowing to ensure smooth transactions in the economy. However, the outlook of loans in the general public has changed today. Because of misuse of lending policies in the past, people today are generally fearful about opting for loans. Although the views on borrowing today are changing with improved guidelines and ease of access, there still exists an atmosphere of mistrust in people’s minds. Today loans can be easily taken by individuals as well as corporates through different sources.

It was revealed from a survey conducted by AbsolutData in 12 Indian cities people usually take loans to fulfil their or families wishes and needs. Shown in figure are top reasons why people opt for a loan.

Fig- Reasons why Indians take loans (Highest to lowest)

Source- AbsolutData

Overall, the country has a positive view towards taking loans. Over 33% of the respondents even believed that it is quintessential to take a loan to enhance their future and lifestyle.

However, a portion of the population are skeptical towards taking a loan. People usually fear that the future is uncertain and in the event of inability of repayment will lead to dire consequences. Some of them believe that saving from their source of income and spending it on requirements is a better way to operate and also less stressful.

Fig- Growth of loans in % in India

Source- Trading Economics

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Public vs Private Source

Looking from a borrower’s perspective, one can opt for loans either from public banks or private lenders. So, which one is better? It is obvious public banks lend at a lower interest rate as compared to private sources.

When one wants to grow a business, banks are a natural first choice given the low interest rate offered. Banks have low cost of acquiring funds and returns required on them thus can lend at a lower rate. On the other hand, private lenders have to first acquire funds from an investor for lending. The investor naturally has a higher expectation of return on the funds he/she invests. This leads to higher interest rates offered loan offerings from private lenders for covering their costs and return expectations.

Fig- Public Bank Lending rates in India

Source- Trading Economics

Although banks have capability to offer loans at lower interest rates, they tend to keep the gap narrow between their offering and private sector lending to get the extra profit. There are many regulations a bank has to follow including lending restrictions which many times prevents them from offering loans to new or very small businesses. On the other hand, private lenders do not have this restriction and can opt for a good investment decision quickly.

Overall, it’s a trade-off between easy loans at higher interest rates compared to lower interest rates with a lot of restrictions in process. A good choice should be based on the value of extra money one is willing to pay if he/she opts for private lender (future growth potential from borrowing).

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When to opt for a loan?

Suppose a person has a vitamin deficiency, the first advice anyone gives would be to consume certain fruits or vegetables for getting those vitamins. If it is not sufficient then it is preferred to take vitamin tablets. Similarly, if one wants to finance a purpose, the first advice is to squeeze the expenses and fund from there. However, if the amount is huge or needed on an urgent basis then loans are an option to pursue.

While opting for a loan one should gauge the returns that he/she would get from utilizing these borrowings and are the returns justified for the interest rate you endure for said period. Also, from a technical perspective one should consider “Tax Shield” while quantifying return benefits. It simply means protecting from the impact of the tax. Formulate a basic model estimating all these benefits to arrive at a decision. Although it is easier said than done, but estimating all this helps in making a rational decision.

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After taking a loan

The first thing is to calculate the portion of your income that will be going towards the repayment of the loan. There is an option to change this in flexible repayment loans. But the loans for electronic gadgets or on vehicles have fixed installments. These calculations need to be done before taking a loan.

Secondly, plan for contingencies ahead of time. After paying installment for a period, make a provision for building a safety net every period. This can be used in case of emergency situations where one might not be capable of paying installment for a period. This will help in protecting the asset or collateral incase of missing an installment.

There are two schools of thought that repayment should be slow and on the other hand, repayment should be speedy. There are 2 aspects to this story. You can save by paying early on the extra interest it would cost you otherwise. Alternatively, you can follow a regular regime and get tax benefits on the payment of the loan. Other factors such as value of future money, need for another loan, life cycle stage and others should also be considered while deciding on schedule of loan repayment

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