Why do we need debt?

Imagine a hypothetical friend of yours. This friend is a software developer at Google. Most likely earns 6 figures a year. Owns a penthouse in the posh section of the city and drives around in a fancy car. By all accounts, this friend would be considered “wealthy” and “upper class”. But while 6 figures a year is a large amount of money, it still wouldn’t be enough to buy you a house in most cities in India. Let alone a penthouse in a posh area and a fancy car even if you spent absolutely nothing and saved every penny. So how is this possible?

Truth is, there are maybe a handful of people in the world who can afford a house and a car upfront, and we generally only see them on newspapers or magazines. But many people, including probably a lot of people you may know, do own the houses they live in. This is made possible by debt.

Debt is when, generally, people, organizations or companies borrow money to be able to afford things they want/need but can’t currently afford upfront. Debt agreements generally include terms like repayment periods, instalment payment terms, and interest rates. This is because loans have to be repaid, and when they are repaid their costs come with a premium. All of this will be discussed further with the aid of the following case study:

Imagine a hypothetical person, let's call him Sohan. Sohan issued a loan worth Rs.40,00,000. His loan agreement states that his repayment period is 12 months with an interest rate of 10%. He has negotiated his instalment terms with his lender upon issuing of the loan. Let’s take Sohan’s case for understanding these items:

A) Repayment periods/Loan Term:

This is when the lender stipulates a certain amount of time in which your loan amount has to be repaid, this varies depending on the loan and the terms & conditions the loan abides by. It is impossible to pinpoint a general figure for this, so let’s understand this through Sohan’s loan

In Sohan’s case, he will have to repay Rs.44,00,000 within the next 12 months regardless of what he borrowed the money for. Here, 12 months would be Sohan’s “Loan Term”.

B) Interest rate:

Interest is the increment to the amount owed at a predetermined rate. As mentioned earlier, borrowing comes with a “premium”. This is an increment to the amount owed at a predetermined rate and is generally expressed as a percentage amount (%). In Sohan’s case, the interest rate is 10% of his principal amount. This works out to 10% * Rs. 40,00,000 = Rs. 4,00,000 and will be added to Sohan’s repayment amount.

C) Instalment terms:

In most cases, the repayment of the loan isn’t done as a lump sum at a particular point in time. Repayment of a loan generally happens at regular intervals of time leading up to a particular point where the terms of the loan are satisfied. This is determined at the time of issuing the loan, and is calculated by factoring in the principal amount, interest rate and loan term.

In Sohan’s case, His repayment period is 12 months. Which would mean he has to pay Rs.3,51,664 every month for the coming 12 months.

But why should debt be preferred over saving up to pay upfront?

While saving up and incrementing your ability to purchase is always encouraged, it may not always be the best alternative when it comes to big purchases. There are multiple reasons for this, but we’ll do our best to narrow them down into a few points

A) It takes a long, long time

As we discussed at the beginning with the case of the hypothetical friend, you could be above the average income level by multiple times and you would still be unable to afford something like a house upfront, much less a nice one. And while yes, you can save up for it over a number of years, subtracting things like cost of living, miscellaneous costs, and so on will greatly expand the time it takes for you to afford

the thing you want/need. Breaking down this expense over much smaller, periodic payments can make things much more accessible and easier to handle.

B) Opportunity cost

Opportunity cost is defined as the value of an opportunity forgone. It basically means how much money you lost doing one thing relative to if you were doing another thing, which is a very real possibility when avoiding debt. Let’s break this down with two contrasting cases:

Ram and Shyam are friends, they both have the same objective to buy two identical houses (worth Rs. 1 crore/Rs. 1,00,00,000) and earn identical income (let’s assume this to be Rs. 10,00,000 per annum) along with having identical spending habits (this being Rs. 8,00,000 saved every year). Ram puts his savings into his savings account every year, which returns him an assured 3.50% and compounds every year. This would mean it would take him 10 years to buy the house, with very little left over. While on the other hand, Shyam took out a loan to finance the house and invested his savings in the market. He reinvests his savings every year after paying his dues (which are 7.50% P.A, therefore Rs. 7,50,000 P.A). If he made the average Indian stock market return of 9.2% upon his remaining Rs. 50,000, he’d have a total of Rs. 8,36,137 at the end of 10 years.

And that is the importance of effectively applying leverage! Shyam was able to secure possession of the house almost immediately, along with ending his loan term with a higher return value. Neither of these benefits would’ve been possible without the effective application of debt.

But the keyword here is effective. If not fulfilled, loans can cause an enormous danger to their bearer as their repayment has to be made, regardless of the bearer’s financial conditions. And if the bearer is unable to repay their debts and files for bankruptcy, it can have long term negative ramifications for the bearer.

And with that, we can understand the importance and effectiveness of debt. Debt is a financial instrument crucial to organizations and individuals alike, and now we have understood why! But remember, negotiate the terms of your debt carefully, and always borrow responsibly.