WHAT IS DEBT?
Let’s go back to school.
If I lend you Rs. 100/- and you repay Rs. 10/-, the amount of debt is Rs. 90/-.
If you borrow another Rs. 30/- from me or somewhere else, the total debt is Rs. 120/-
If the unpaid interest on this amount is Rs. 12/-, the total debt is Rs. 132/-
So, debt is the amount that one owes others today, including both principal and interest.
WHAT IS DEBT MANAGEMENT?
Debt Management is a vast term.
What exactly do you wish to achieve?
- Keep your head above water (financially)
- Manage your credit scores
- Reduce the total debt
- Reduce interest payments in the short or long-term
- Repay a loan fully to make space for another one
- Get out of a bad mess when creditors are chasing you from all sides.
One needs to address the causes of debt delinquency, before the process of debt counselling or debt management starts.
CAUSES BEYOND CONTROL
- Job loss
- Family problems
- Overspending to boost social esteem
- Falling prey to aggressive marketing of financial products
- Over-leveraging assets
- Being a habitual defaulter
Personality disorders need to be treated by a therapist.
Financial behaviour can be corrected with the help of a financial coach.
Debt counsellors can help with cases where a financial action plan can be devised to clear off outstanding debt.
DEBT MANAGEMENT FOR FINANCIAL WELLNESS
A debt management plan is meant to ensure your financial well-being, with the following measures.
- pay minimum possible amount of interest
- stay debt free in difficult times
DEBT MANAGEMENT VS DEBT SETTLEMENT
Debt settlement companies negotiate with the lenders for a lower amount to be paid.
However, collection agents may approach you till the settlement proposal is finalised.
Settlements have a negative impact on the borrower’s credit score.
Needless to say, debt settlement companies charge a fee for these services. Debt management can be an individual initiative.
HOW DOES A BANK ASSESS YOU?
Monthly repaying capacity
- Bank needs to recover money in monthly instalments, so monthly income matters. It is the net take home pay for a salaried person, excluding incentives, overtime, bonus etc.
In case of a businessperson, bank statements of the current account are taken to assess the monthly inflow of funds.
- Security given (in case of secured loans) which the bank can liquidate to recover money in case of default.
Let us take the commonest cases first.
In case of a term loan like personal loan, vehicle loan or home loan, the bank calculates eligibility as follows –
Total EMIs paid in a month should not exceed 40% of your monthly income.
Some experts break it up further from a consumer perspective.
Personal loan 10%
Car loan 15%
Home loan 33%
Overall, loan instalments should not exceed 35%-40% of your take-home income.
However, this is a thumb rule for general guidance. One can borrow more for a house, due to expected appreciation in value.
WHAT IS OVER-LEVERAGING?
Leverage is utilising existing assets by raising money against those.
Over-leveraging means that you continue to incur more debt which stretches your finances.
You may buy furniture or gadgets on EMI from a dealer, borrow from a money-lending app which is not licensed by RBI or borrow from friends or family. The bank had not accounted for this in the 40% calculation, and now finds it difficult to recover money from you.
WHY DOES OVER-LEVERAGING OCCUR?
Morgan Housel says in his book, “The Psychology of Money”, that people are greedy by nature. They think they can multiply wealth by putting some assets at risk.
It is calculated gambling, but the assumptions made are not always correct. Those can backfire.
SHOULD YOU TAKE ANOTHER LOAN TO SETTLE A PREVIOUS DEBT?
Debt recovery agents from credit card companies always ask you to pay the minimum amount due, and protect your credit score from a negative impact.
What happens when you pay only the minimum amount due?
The remaining outstanding amount starts getting charged at a rate of 3% to 3.5% p.a.. It means an interest rate of 36% p.a. to 42% p.a.
It is the highest rate in the banking industry for any kind of loan.
Just in case you have been naive enough to accumulate a credit card debt, it makes sense to take a personal loan at 13% – 16% to settle the credit card debt.
Students going abroad often take a student loan at the rate of 8.5% – 15% p.a.
Once they complete their studies and start working in a Western country, they are eligible for credit at lower rates of interest, since interest rates in those countries are low.
It makes sense to raise money in that country, and settle the education loan here. It also frees the collateral (property or a FD) which the parents may have placed with the bank. In certain cases I know, the same collateral was placed with the bank again to get an education loan for a sibling, thus, increasing the leverage for parents.
CAN I GET LOAN INSURANCE?
Yes. Loan insurance can be taken to cover the risk of something unfortunate happening to the borrower.
The insurance company pays the outstanding amount of loan, thus protecting other assets from being claimed by debtors.
These are loans with long tenors, and uncertainty abounds. Other than government jobs, there is no guarantee of continuance of income for 20-25 years in any field. Some government employees too have seen salary cuts in the Covid-19 economy.
The comfort level lies in appreciation of property value in the long term. This is what gives people the courage to borrow large amounts, and banks the will to take a risk. One may assume a rate of appreciation of 8% p.a. on property. However, this will vary widely for different geographies and state of the economy and real estate markets.
Total interest paid exceeds the principal amount, where the tenor exceeds 12 years.
Pre-EMI interest can blow up, if the builder delays giving possession of a flat booked in a project under construction.
Home loan insurance, maintenance charges, property tax, repair and renovation and any other kind of insurance taken are all additional costs.
Let us examine this from the point of view of reducing the total interest payable.
Interest is charged on the principal amount outstanding.
So, any prepayment which reduces the principal amount of loan, will also reduce the interest paid in future.
How does one go about it?
- Use a bonus, incentive, leave encashment or any unexpected inflow to prepay the loan.
- Salary increments can be used to pay increased EMIs and settle the loan faster.
Financial advisors will give you several options
- Start a SIP in Liquid/Bond fund and pay off every year
- Increase EMI by same amount
- If horizon of repayment is more than 5 years, start SIP in equity MF, and repay a large chunk at the end of that period.
- Balance transfer
There is no one-size-fits-all solution here.
A solution will depend on the risk appetite of the borrower, and the criticality of debt settlement.
If the market goes down, the SIP strategy can badly fail.
The rate of return on your investments should be higher than the interest on your loan. Otherwise, it makes sense to just use the extra amount to settle the loan.
Stay on your toes all the time.
See which bank has reduced interest rates, and get the loan transferred.
If the difference in rate of interest is 1%, you pay Rs.1000/- p.a. extra in a year.
Home loans are usually in the range of 25 lakhs to 1 crore, so you may be paying more in the range of Rs. 25000/- to Rs. 1 lakh in a year.
If the difference in rate of interest is more than 1%, you can keep multiplying to calculate the excess amount you are paying.
Calculate the extra amount you will pay on the outstanding amount, for the remaining period, if you continue with the existing lender.
Floating rate loans do not carry a penalty on prepayment or balance transfer.
Does it make sense to switch lenders with a balance transfer?
If you are looking for help with debt management, there are debt settlement companies (mentioned above) and debt consolidation companies which come to your rescue.
DEBT MANAGEMENT VS DEBT CONSOLIDATION
Consider a scenario of this kind
|LOAN||OUTSTANDING AMOUNT (INR)||RATE OF INTEREST (% P.A.)|
The debtor here is not savvy, and does not know which loan should be cleared first – the one with high interest, or the one with the highest amount outstanding.
There are agencies which give a single loan to settle all outstanding debt. The agency works out an EMI which the debtor can conveniently pay every month, though the tenor may be longer.
The advantage to the borrower is that he can now plan his finances around that single EMI.
It does have a negative impact on credit scores.
Some debt consolidation companies in the market
2. Rupee Circle
Tread carefully after checking the company’s license, registration, physical address, reviews etc.
COVID19 – MORATORIUM ON EMIs
The moratorium generated more confusion amongst borrowers than relief.
The terms and conditions were very clear –
- Banks allowed a break from 1st March, 2020 to 31st August, 2020 for payment of EMIs
- It did not mean that EMIs were being waived off.
- The full amount with compound interest was to be paid after 31st August, 2020
- Non-payment during this defined period will not qualify the account as a non-performing asset.
- However, if the payment of EMIs was not regular before 1st March, 2020, the NPA tag would apply
Subsequently, the Supreme Court ruled that compound interest should not be charged during the moratorium period.
Banks contended that a loss of interest on loans will lead to further reduction of rates of interest on deposits.
Finally, the Government of India decided to foot the bill of compound interest as a one time measure for Covid-19 relief.
For an individual investor, debt management tips are repeated.
- Those who could afford to pay should have paid regular EMIs, as there is no point in paying extra interest or getting the tenor of loan extended.
- For those who could not pay due to genuine difficulties, banks have been asked to restructure loans at their discretion. It has not taken off well, as all defaulters are not being offered the restructuring package.
- Bank NPAs are going to mount by September, 2021 and the defaulters will suffer the consequences of being classified as NPA accounts.
Stay financially safe and healthy!