Should you take a loan to cover an emergency?
Should You Opt for a Loan to Handle Emergencies?
Many individuals tend to resort to loans when dealing with financial emergencies and investments. However, is this a prudent financial move? Let's explore the associated risks and potential pitfalls.
The Role of an Emergency Fund
Emergency expenses encompass crucial living costs that one cannot compromise, such as food and shelter. Situations like temporary disability, job loss, or delays in insurance claims can disrupt your income, necessitating the need for funds. Consequently, one of the initial steps in financial planning involves addressing unforeseen risks or emergencies. Beyond health and life insurance, it's essential to establish an emergency fund to tackle unexpected financial setbacks. This contingency fund acts as a safety net and should be created before embarking on any investments. It is intended to cover expenses in the event of unforeseen income loss.
At Dilzer Consultants, we follow a rule of thumb: for households with dual income earners, an emergency fund equivalent to 3-4 months of living expenses and liabilities is recommended. In the case of a single-income household, it's advised to allocate an amount equal to 6-8 months of living expenses and liabilities. Ideally, this amount should be maintained in a "Sweep-in-FD" facility, offering flexibility and ease of access.
The Cost of Neglecting Your Emergency Fund and Relying on Loans
Many individuals resort to loans when facing financial crises due to the absence of an emergency fund. They might borrow from friends, family, or opt for personal loans, incurring interest expenses. In dire situations, some individuals may even pledge assets like gold to overcome financial hurdles. However, these actions are generally desperate measures and should be avoided. Some reasons against using loans to address emergencies include:
- Personal loans for emergencies often come with higher interest rates compared to other loan options, exacerbating your financial liabilities during an already challenging period.
- It can disrupt your cash flow, making it difficult to meet additional financial obligations when already grappling with a loss of income.
- Loan eligibility and creditworthiness need to be assessed, and past credit history with credit rating agencies like CRISIL should be considered.
Is Borrowing for Investment a Viable Option?
Loans for investment purposes primarily involve personal loans used to acquire assets. The value of these assets is subject to fluctuations, much like typical investments. However, taking loans for investments is a somewhat risky endeavor, as predicting asset value changes is inherently uncertain. Risks associated with investment loans include:
- Investment income risk: The returns from investments may not meet your expectations.
- Interest rate risk: Rising interest rates on the loan could result in higher repayments that may not justify the returns from your investments.
- Income risk: Loss of income due to illness, injury, or job loss can make loan repayments challenging.
- Capital risk: The value of your investments may decrease, and the proceeds from asset sales might not cover the remaining loan balance.
Precautions When Considering an Investment Loan
Before opting for an investment loan, certain precautions are vital:
- A sound understanding of the markets and investment products.
- The ability to repay the loan even if your investments underperform.
- A strong creditworthiness to secure a loan.
- Diversifying your investments to reduce risk, as putting all your funds into a single asset or industry sector can be precarious.
In conclusion, taking loans for investment purposes is not typically recommended. Given the high risks involved, seeking professional financial advice is advisable to assess whether this strategy aligns with your financial goals.
Author: Debalina Roy Chowdhury, Dilzer Consultants
Sources: