Many have the habit of taking loans for investing and emergency needs. But, is this a wise thing to do? What are the risks and pitfalls?
The purpose of an emergency fund
Emergency expenses are living expenses one cannot go without in case of emergency, like food and shelter. There could be a setback to one’s earning capacity due to a temporary disability or a job-loss. Even a medical emergency may crop up any time when the claim takes time for settlement or the ailment itself may have a waiting period. In all such cases, one may have to arrange funds to tide over the situation.
Thus, one of the few initial steps in the financial planning process involves taking care of unforeseen risks or emergencies. Besides being protected through health and life insurance, one needs to create a corpus so as to meet any other financial emergencies. To take care of this, a person should create an emergency fund before making any investments. This contingency fund will take care of expenses in case of any unforeseen loss in income.
Emergency fund thus acts as a safety net and is not for meeting planned goals. At Dilzer we follow the following thumb rule- IN case both spouses are working- an emergency fund equal to 3-4 months of one’s living expenes and liabilties are considered. In case only one spouse is working an amount equal to 6-8 months of one’s living expenses and liabilities should be apportioned. The amount should ideally be maintained in a “Sweep-in-FD” facility that provides the flexibility and convenience of easy withdrawal.
The cost of not maintaining an emergency fund and taking loans instead
Many people use loans as a way out of a difficult financial situation in the absence of an emergency fund. They may either borrow from friends/relatives or take a personal loan and service it by paying interest. If the requirement is huge, one may even pledge gold to tide over the situation. This is a desperate move which should be avoided.
A few arguments against taking loans to deal with an emergency are mentioned below :
- Taking a personal loan for emergency expenses bears higher interest rates than other loans, A loan will increase EMI liability, which might be tough to meet when one is already facing loss of income under an emergency.
- It will affect one’s cash flows.
- No Guareentee of Loan eligbility and past track record with CRISIL rating agency to be checked.
Should you take out a loan for investing?
The Purpose of Loans for investing
Loans for investing are basically personal loans, the funds of which are used to acquire assets. The value of these assets may fluctuate in either direction over time, as most investments do. Thus taking such loans are a bit risky, as it is impossible to predict in which direction the asset will move.
Risks in Loans for investing
Loans for investment (that is, investing on borrowed funds) brings with it several associated risks. They are:
- Investment income risk – The income received from the investment may be lower than expected.
- Interest rate risk – Interest rates on the loan could rise which implies higher loan repayments which may not justify the returns earned on the investment.
- Income risk – If income ceases due to sickness, injury or redundancy making loan repayments may be difficult.
- Capital risk – The value of the investment may fall and the proceeds from the sale may not cover the remaining loan balance.
Few Precautions to be taken while taking a loan for investing
Before taking a loan a few things should be taken care of :
- One should have enough knowledge about the markets and or the products of investmentOne should be able to repay the loan should things go sideways: If one has the means to repay the loan if the investment fails, borrowing money to invest can be a good way to make money without actually taking anything out of the pocket. If, however, there are no funds to back up the loan it is not a good idea at all. Also the need may arise to repay the loan after having to sell an asset at a lower price than it was paid for.
- One should be creditworthy enough to borrow money:
- One should make sure that investments are diversified while taking a loan: Diversification reduces investment risk and exposes one less to a single economic event. If one business or sector where a person has invested fails or performs poorly, the extent of loss is very less. The less diversified the investments the higher the risk. It is risky to borrow to invest in one company or one property or one industry sector.
To conclude, taking a loan to invest is not recommended. Borrowing to invest being high risk, it is better to seek professional financial advice to make sure this strategy is right or not.
Debalina Roy Chowdhury