A couple of years ago, I longed for a new iPhone, so I rushed to buy that new version, a dazzling piece of tech; I mean, who doesn’t, right? Well, I hadn’t thought this through. You see, I didn’t have the whole amount saved up to buy this phone. The first thought I had was to finance it by taking a loan. Not a very smart financial decision to make! 

Excerpt from Times of India article.

I took out a loan and bought that phone, only to realize that I was committing to paying not just for the device but also the interest on the borrowed amount. Over time, I had shell out more in interest than the iPhone’s value will ever be worth. 

Lesson learnt there! Depreciating assets like gadgets, electronics, cars, etc, lose value rapidly. If you make these purchases with a loan, you may find yourself in a situation where you owe more on the asset than it’s worth. This is also known as negative equity. It can be financially burdening, especially if you need to sell that asset.

 

Let’s break it down a bit more. You know when you buy a car, and then you decide to sell it later? Well, usually, in the first year, that car’s value drops by about 15-20%. And if you wait for three years, it can lose about 30% of its value or even more.

Now, imagine you’re taking a loan to buy a car, and you choose a long loan term, like 8 years. Your car is now losing a lot of its value during those years, but you’ll still be paying off the loan with interest, maybe even more than what the car is actually worth. That’s not a great deal, right? 

Data from Cars 24’s article on car depreciation.

The above table shows your car will be worth half in five years. The table below shows you will end up paying almost 1.3X of the loan amount.

Assessing the need for a loan is essential, except for those unexpected emergencies where you have no choice but to seek immediate financial help. Availing loans for anything depreciating in value may tie a significant portion of your monthly income, leaving you with little flexibility to save, invest, or respond to unexpected financial challenges. 

This reduced flexibility can hinder your financial stability and limit your ability to pursue other goals. Also, this could expose you to the risk of defaulting on your loans. Defaulting can have serious consequences, like messing up your credit score, which might mean you won’t be able to get a loan when you need it, especially in a pinch or emergency. So, here’s something to ponder this week. 

Happy Investing 🙂

This post is by Kulsum at Zerodha, a multitasking enthusiast with a strong affinity towards coffee!