The ‘leverage’ factor- how a personal loan can help individuals

‘Money buys goods and goods buy money but in a monetary economy, goods do not buy goods. Really, without money, the world would not go around.’ -Bob Clower, economist It’s said that money can’t buy you happiness but then, lack of it can make you unhappy! One can feel the pinch of monetary shortage when one invests in a big-ticket transaction like a house property, which is prone to price rise from inflation or even buying items of consumption like appliances or clothing. It’s not uncommon to land in a tight spot, financially. In such a scenario, to fund the shortfall of cash, an unsecured personal loan can be a lifesaver! Even in corporate finance, financial experts advocate leverage as a powerful tool for business growth, irrespective of the size of the business entity. Leverage in simple terms is external borrowing or loan. Thus, leverage works in both the corporate as well as the individual context. An unsecured loan is extended to individuals for personal use, without the need for the pledge of any valuable assets as collateral.

While there is endless debate around whether borrowings are boon or bane, there’s no denying that while loans are helpful, overleverage can be dangerous. How much borrowing is too much? Consider some data doing the rounds. RBI data suggests that unsecured personal loans and credit card borrowings comprised $82 billion (FYE 18). Considering that India's FDI inflows were $44.86 billion during the same period, the borrowings are almost double. With loan digitalization, convenience and accessibility factors like getting a personal loan in no time, payday loans, EMI free loans, unsecured borrowings, conversion of purchases into EMIs and online loan application, Indians are gravitating big time towards the borrowing club.

A 2018 CRISIL report supports this enhanced loan culture, whereby the unsecured lending books grew at 4x times compared to bank loans to business. With a 5 year CAGR of over 20%, personal loans are becoming the way to go. With higher penetration levels, personal loans are becoming largely democratised. There is a parallel concept in Monetary Economics called as velocity of circulation of money. In other words, how often money changes hands to purchase consumption goods. In fact, economists believe that one of the key features of the financial crisis of 2008 was a huge fall in the velocity of money. Whether one is in the danger zone or safe zone can be roughly estimated by the personal leverage ratio. There are many angles by which leverage can be computed i.e. the debt servicing capacity, the income coverage, the asset-liability angle. Since in personal finance decisions, the sources and uses of funds are already known, it would be useful to consider the debt levels in comparison to one’s assets. What does this mean? For example, if you used your credit card to fund the acquisition of a consumer durable, the source and use of the fund is clearly demarcated.

Personal leverage may be computed as total liabilities divided by the total assets. Expert recommend that this should ideally be less than 50%. A useful thumb rule would be to borrow only i necessary and when necessary. In case of borrowing towards ‘not so productive' use, it is best t settle such debt at the earliest extent possible. Of course, most importantly, never borrow beyon your means. One must determine the EMI repayment capability based on one’s income position This would prevent falling in a credit trap or a debt trap, a vicious cycle of borrowing further to repa existing debt.