The last few years have seen a substantial rise in the personal debt of individual families in India. This is in the form of credit card outstanding balances (many people don't even realise this is a debt), personal loans, vehicle loans, home loans etc.
The reason for this is, of course, quite obvious:
- Booming economy with rapid increase in income levels
- Double income families
- Low interest rates
- Easy availability of finance & convenience
- Hard-selling by the lenders
- Unbridled consumerism
But debt is, in effect, spending tomorrow's income today. Therefore, as long as the going is good, there's no issue. But suppose
(a) There is a setback to one's income (job losses are not uncommon) or
(b) There is some emergency (medical problems, natural/manmade disasters etc. are also not uncommon) or
(c) If the interest rates become too high (could happen if the inflation does not come under control soon).
God forbid if things turn bad, then debt could become a really serious problem. Therefore, we must be extremely careful and smart in the way we manage our debt.
Before you take-up a debt, you must keep three things in mind:
What is it financing?
Paying for the parties or dinners through credit card is very common. As long as this is within your paying capacity and you will clear the bills on the due date, then it's OK. But if you are going to roll-over your balances, then you are using your credit card debt to finance consumption. Or if you are going on a vacation abroad under an EMI (equated monthly instalment) scheme, again you are financing consumption. This is definitely the worst form of debt and must be prevented.
If instead, you are buying a house or a car through a loan, that's fine. You are, at least, buying an asset.
So ideally speaking, debt, which builds assets for you, is OK.
Is it within prudential norms?
Second important point is to keep your debt within manageable levels, even though the lenders may be willing to lend you large amounts.
This can be checked by calculating your 'debt service cover ratio', which is nothing but Debt service cover ratio = Monthly payment of all loans / Monthly take home-pay
Broadly speaking, if you have no significant liabilities, then this ratio should not exceed 40-45%. And, as you near retirement or add any liabilities, this ratio should be suitably reduced.
Also, the ideal ratio will depend on the type of loan. For example, for home loans 40-45 per cent ratio is fine. But for personal loans, the ratio should preferably not exceed 15-20 per cent and for credit cards it should be less than 5-7 per cent.
Are the terms competitive?
Shop around for the best deals in terms of interest rates, convenient repayment schedule, and minimum prepayment charges etc. The financial jargon can sometimes be confusing. So if it sounds too good to be true, it should raise warning signals in your mind. Remember, it is better to be safe than be sorry.
But if you have already breached the above guidelines, you can still try to bring the things under control.
Consolidate your debts
If you have too many loans like multiple credit cards, personal loans, home loans, vehicle loans etc. it will be difficult to keep track of all these and make timely payments on the respective due dates. You could therefore, for example, transfer the balances on your various credit cards to one card. Or you could take a personal loan and pay-off all your credit card outstanding balances. This will consolidate all your small loans into a single debt, making it easy to manage.
Pay-off 'bad' loans first
The credit card debts and personal loans are the so-called 'bad' loans. One, they primarily finance consumption and two the interest rates on these are comparatively very high. Therefore, take immediate steps to clear-off these loans at the earliest.
Refinance your loans
Another smart way is to borrow against your LIC policy, mutual funds, equity, etc. These loans are comparatively much cheaper (maybe around 10-12 per cent) because they are secured. Secondly, they can be paid in convenient installments vis-à-vis say a credit card debt, which has to be paid fully, or it starts attracting compound interest. Third, these loans give you more time to repay. Use this money to pay-off all your high-interest 'bad' loans.
In fact, many a times it is seen that people have money in a bank fixed deposit (where they earn say 7-8 per cent) and still have credit card debt/personal loan (where they pay anything between 18-36 per cent). This makes no sense and this FD should be used to pay-off such high-interest loans.
All this will result in huge benefits in terms of
- Reduced debt burden
- Lower interest outgo
- Convenient payment schedule
- Less no. of debts to keep track off
- Not being bothered/harassed by the lenders
Therefore, get smart with your debt 'NOW'. Don't let it become such a big burden that it affects your personal relationships, causes emotional trauma, lead to loss of social standing and in the worst case cause you to lose your home/car/other assets.
The author, Sanjay Matai, is an investment advisor and can be reached at sanjay.matai@moneycontrol.com
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