If you have a financial planner with a ‘product sale’ mentality – especially who has sold loan products also in the past, there is a good chance that he would suggest leverage. Leverage means borrowing. So read on…
Financial planner: Borrowing sensibly is a good way to build wealth. Do a disciplined borrowing and you will make money because the equity market moves faster than the interest rates that you pay on your borrowing. This logic can be made to look even more convincing with graphs and charts!
You should: Borrow cautiously, if at all. You have to worry about the total amount of debt too! The quarter-century leading up to 2007 wasn’t simply a golden age for stocks. It was also a bull market for leverage. (That’s Broker’s Bluff for debt.) Since 1999, mortgage rates have fallen, college loans have ensured that parents can hold on to assets while their kids borrowed. Cars, scooters, mutual funds were all available on loan! People responded to easy credit in a predictable way. Houses got bigger, shares were not for investment – they were for ‘call options’ and ‘futures’ – again naked debt! The personal savings rate fell, and household debt payments as a percentage of disposable income rose. Home up grades ensured that big houses were furnished big, EMI was bigger.
Looking back, retail investor (ok I should call them traders) borrowing binge was bizarre. But it didn’t feel that way at the time. There were retail traders who would have a leveraged position on the buy side on a single share and a leveraged position of a single share on the sell side. It was a brokers delight – surely the brokerage generated was far, far greater than the wealth created for all the investors put together. This was stunning, and RBI too should have been perplexed if the overall picture was available on one page! Forget the common man in India, Alan Greenspan thought everything was hunky dory.
If you watch Suzie Orman Show you cannot believe that nobody in USA was bothered about the leverage based on ‘ever-increasing’ housing price spiral. Indian bankers did not give Rs. 500,000 loan to a fruit seller with a Rs. 17000 annual income. In the US it was easy to get NINJA (No Income No Job Applicants) loans.
The obvious moral here is to be conservative. There are always good reasons to borrow, even today. You need to borrow to get a good education, you need a mortgage to buy a house, maybe a car loan – of an affordable size. However when buying a house you can always pay 50% down payment installment instead of 10% which the banker was asking for.
There’s a subtler lesson too. When leveraging keep an eye on the total borrowing. Lehman was so smart! They failed first. Bear Sterns did not get the bail out. The overall leverage hurts when EVERYBODY tries to give up the debt. Maybe your builder has gone under and he is pushing you for EARLY installments. Your employer may be laying people off to reduce leverage. Your equity portfolio may be doing badly – and your banker may be making margin calls on your mobile. Suddenly that PMS you could “easily” handle on your salary does not look like a great idea. You cannot depend on your equity or debt for help, because many of the companies you owned are revealing their true leverage and the market is furiously re-rating. And your extra bedroom which you bought cannot increase your cash on hand by selling ‘just that room’. Banks are no longer falling all over you to increase leverage – cards, cars or a foreign trip.
MUST DO: Be conservative about debt. Make that very conservative. Especially when your neighbors aren’t. Get a mortgage you can afford for the life of the loan, and put at least 35% down payment. Furnishing or home improvement loans make no sense – spend on consumables from your income. Just because a loan is available you do not have to take it. Taking a loan is easy – sometimes repaying becomes difficult.
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