Why do I say that debt is your first obstacle for financial freedom?
As I write this blog today, tragic news is pouring in about the suicidal death of Mr V G Siddhartha, founder of Cafe Coffee Day, an icon of Indian entrepreneurship.
Siddhartha was born into a very wealthy family of coffee traders.
“I could have continued in my family business, but I did not want to retire at 21”.Mr V G Siddhartha
He built a conglomerate around his coffee business, provided jobs to thousands of people, built an iconic brand, all of which makes it more tragic. The company is under a debt burden of around Rs 7000 crore and is facing a severe liquidity crunch. The future is hazy.
I think, he had also borrowed personally and around 75% of his equity stake was pledged with the lenders. He was trying to raise a fresh loan, sell off assets, negotiating a stake sale till the day he decided to end it. It is really saddening the way it has all ended for him.
The Real Cost of Debt
Debt is serious and needs to be taken seriously. It is a legal and moral obligation to the lender which in effect, brings the borrower into servitude.
This reality is so well obscured by the marketing propaganda which makes people believe that everything they desire can be had easy. All it requires is a few more EMIs.
One of the other things, that we fail to recognize is the huge opportunity cost that debt brings on. Due to debt EMI obligations, the disposable income required for investing long term and creating wealth is reduced to a minimum.
This is a lost opportunity to create wealth for the long term. If you consider this, in fact, the cost of debt is much more than the interest you are paying.
For those who want to keep their feet firmly planted on the ground, it is always better to save now and buy later rather than buy now and keep paying. However, I understand that this approach may not be feasible always, especially while making large purchases – like buying a house.
When is taking on Debt Reasonable?
Here are 3 rules that will help you make a decision on whether or not to borrow
- When the mortgaged asset appreciates or earns income
If you are buying an asset by taking a loan, and that mortgaged asset appreciates in value over the tenure of the loan or produces an income – it might be safe to take on such debt. This principle would mostly stand true in case of real estate purchases. Real estate would usually appreciate in value over time and it also has the potential for earning rent which makes it a good candidate.
Business debt would also make a strong case here. But again, the extent of leverage needs to be carefully thought about. Revenue projections on paper may not materialize in reality which then pushes the business into a cash crunch. So, when you are taking on debt on the basis of expected income, you need to play it safe.
If it is an asset that depreciates over time – then its better to save first and avoid debt. The amount of debt has to be negligible, which can be retired quickly.
- When the value of item is greater than amount owed
This is where the extent of downpayment kicks in. Although this point is very much related to the earlier one, the difference would be where the asset doesn’t appreciate in value. So, the downpayment has to be much more than the debt portion which would make it easy to sell the asset and retire the debt in case of an emergency.
- No undue strain on the budget
When the interest cost is causing a huge strain on your budget, it is certain that the borrowing levels are high. Repayment capacity is usually an estimate of future earning capacity. These numbers can go horribly wrong in a bad market. So, again, projections need to be grounded in reality and be prepared for the worst.
Once an amount is borrowed, you need an aggressive plan to repay it as quickly as possible to become a zero debt individual / business. Most people take it casually and they are not really aggressive about getting debt free.
- Freedom from debt relieves a huge amount of stress both as an individual and as a business.
- Allows you to take bold decisions for the future
- Releases your investible income for long term wealth creation
- Frees you from servitude and makes you the master
There are two approaches to repaying debt:
- Paying off the high interest debt first
This is an obvious one. List all your debt obligations and order them according to the interest cost.
Start paying off the one which has the highest interest cost and then go down to the others.
This will help you save a huge amount of interest
- Paying off the smaller loans first
There may be situations where you are unable to fully retire the high cost debt quickly.
You may get disheartened and quit the entire process of getting debt free because of the long process.
Hence you need smaller victories first to help you stay motivated.
This is where this approach is helpful. Pay off all the small loans and keep striking it off your list.
As the clutter on your list starts to clear, it will also help you to clear your mind and stay focused on the goal for overcoming debt which is the first obstacle for financial freedom.
This is a simple technique which you can use to pay off debt faster.
Start paying a higher EMI on the loan you want to tackle first. This way you will be repaying a higher amount of the principal and thereby reducing your interest cost. You will also finish off the loan faster than the original tenure.
Once you finish off your first loan, you will have more money at your disposal every month. Do not spend this money.
Use it to pay a higher EMI on your second loan. This will enable you to pay off your second loan much faster.
And so on….
Let’s see this in action through an example. Suppose you have 3 loans.
- Car loan – EMI Rs 10000
- Personal loan – EMI Rs 15000
- Housing loan – EMI Rs 30000
Out of the above, the personal loan is will be the one with the highest interest cost. Let’s tackle it first and then we will go after the car loan and finally the housing loan.
- If you can pay Rs 3000 extra every month, talk to the lender and increase your EMI on the personal loan to Rs 18000.
- Obviously, this will help you to cut down on the tenure of the loan as well as save interest cost.
- Once you have paid off the personal loan, now you have Rs 18000 extra every month.
- Increase your car loan EMI to Rs 28000 (Rs 10000 + Rs 18000)
- You can retire your car loan in double quick time.
- After paying off your car loan, start tackling the housing loan.
- Now you have Rs 28000 extra every month.
- Increase your housing loan EMI to Rs 58000 (Rs 30000 + 28000)
I hope you get the idea. There will be a huge saving on your interest costs if you follow the above plan.
And the greatest factor will be a huge relief from the debt burden that you are carrying.