Difference Between a Good Loan and a Bad Loan

We often hear that loan is a bad thing, this notion really holds true specially in a country like India. But the problem is that there are two types of loans, the good ones and the bad bad ones. And if we do not understand the difference between these two early in our lives we often find ourselves on the wrong side of the court.

First lets understand what is a loan if we were to understand in a non finance language. Its basically committing your future energy to something that you want today. Meaning you are making a deal with someone that: you give me X now and I will give you Y for the next 5 years of my life. Its as simple as that, you are getting energy today and promising to pay energy in future.

Now lets see what makes this good and what makes this bad. Lets say someone promises that I will give you a phone which will give you happiness for the next 3 years of life and you can repay me by giving me money for the next 3 years of your life. Now this looks like a great deal, you are getting energy (Happiness) today in exchange of paying energy (Money) for the next 3 years. It is indeed a great deal until it isn't…

You buy that phone, get the social status which comes along with it but in 4-5 months it fades… and now you end up paying more than what you got. This makes you end up in a situation where you paid more energy than what you received. This happens with so many goods and services in our lives — Gadgets, Big Fat Indian Weddings, nowadays people also buy clothes on an EMI. Basically any loan you take to buy anything which you think will make you happy and earn you rewards for a longer time but actually ends up a dull thing which gives you a temporary spike will always turn out to be a bad loan.

So are all loans bad? Obviously not. You take an education loan and you end up getting the benefits of that in the form of money you earn for the next 20 years of your life. You buy a house on loan, you end up getting safety, capital appreciation for the next 30-40 years of your life. You take a loan for your business, you end up getting leverage in your business and you grow faster and you get more energy (Money) for the next 20 years of your life. So in all cases where you can see the energy that you are getting today outlasting the energy that you will have to pay in future can be classified as a good loan.

I wish it was this straightforward but its not.

Many people who take education loans do not take it for the education but take it to earn the social status of "Studying Abroad" — unfortunately that social status fades in 2 years, much shorter than the loan. Many people who buy a house buy it to show their relatives that they are rich and even that social status fades away much shorter than their EMI. In business specially, that leverage comes as a double edged sword — too much leverage can destroy your business if you aren't prepared for the worst case outcome.

The first parameter to differentiate a bad loan and a good loan is whether it is giving you a higher payoff than what you are going to give them in future. Most of the times this criteria will be fulfilled only if you buy assets — e.g. House, Business, Education. All of these are assets. And most of the times when this criteria won't be fulfilled it would be for unnecessary consumption, like buying an expensive phone or shoes or a watch.

The second parameter would be to check that the asset that you are buying with this loan — are you truly buying it for the asset nature or just fooling yourself to get the social status which comes along with it. For business, ask yourself — have I incorporated the worst case outcome and thought about what will happen? Or am I in denial thinking that that could never happen?

A loan can make your life as well as destroy it. The onus is on you to pick a good loan rather than a bad one.