• SEPTEMBER 29, 2016

10 Things to Keep In Mind before Making Long Term Debt Commitments

The National Sample Survey Office (NSSO), Ministry of Statistics and Programme Implementation (MOSPI) released the key indicators of debt and investment in India, on December 2014. The data collected during January 2013 to December 2013 in its 70th round survey. The last survey was conducted in January 2003 to December 2003.

The survey aims to generate an average value of assets, average value of outstanding debt per household, and incidence of indebtedness. The survey included 4,529 villages in rural areas comprising of 123,785 households and 3,507 urban blocks comprising of 95,436 households spread over all States and Union Territories in the country.

According to the survey, the average value of assets (per household) in the rural area was Rs 10,06,985 and Rs 22,85,135 in urban areas. The percentages of indebted households were 31.44% in rural areas and 22.37% in urban areas.

Although, the percentage doesn't seem appalling, it is important to realise that an excess of debt is toxic and can lead to sleepless nights. However, the mantra in today's materialistic world is-more is better. People tend to buy more than what they can afford and inadvertently fall into a debt trap.

Financial Planning has more to do with one's attitude towards money and the habits one subscribes to, and not only deploying hard-earned money across investment avenues. Mind you, inappropriate attitude can permanently put you off track.

In this article, we'll take you through host of facets you should look into, to be in better control of your personal finances in the interest of your long-term wellbeing.

  1. Know your finances precisely: It is extremely important to have a clear understanding of your monthly cash flows (cash inflow and outflow). Draw a budget; it brings about much needed discipline and gives a picture of how hard-earned money is being spent, and take a corrective course if need be.
  2. Ascertain why you are borrowing: Borrowing money for important life goals like buying a house may be unavoidable. However, checking one's ability to repay the EMIs on time is very important. So, borrow only the amount that can you can repay comfortably; or to simply put, bite as much you can chew to avoid the discomfort later. Wherever possible live by the rule of living within your means.
  3. Recognise what will be Debt-Income Ratio (D/I): D/I ratio indicates how much debt is used to finance the assets. Higher the D/I ratio; higher the trouble. As a thumb rule, the total monthly debt commitments (e.g.: Mortgage payments, credit card payments, car payments etc.) should not exceed 25% of your gross income. For example, If your monthly gross income is Rs 50,000; then your total monthly debt contribution should not exceed Rs 17,500 (50,000 x 35%).
  4. Ascertain how you're going to repay the loan: To avoid burning a bigger hole to your pocket as a penalty, timely repayment of the loan is a must. So, if you're thinking of availing a loan, ascertain the bearing on your household budget. Account for it and take into account and recognise the interest rate cycle you would be in if you're opting for a floating rate loan. Take a loan during a floating interest loan during a rising interest rate scenario can be perilous.
  5. Check the repayment schedule: It is prudent to check the repayment schedule before signing up for a loan. The repayment schedule gives an idea on the total borrowing costs (including the interest payments). It is important to note that the total interest rate will increase with tenure in case of a floating interest loan increasing the total interest outflow.
  6. Calculation of interest saved on a Car loan of Rs 500,000 at 11.25% p.a.
    Particulars 5 year loan 6 year loan 7 year loan
    No. of payments (A) 60 72 84
    Monthly payments (B) (Rs) 10,934 9,581 8,627
    Total payments (C) = (A x B) (Rs) 6,56,040 6,89,832 7,24,668
    Interest saved by taking the shorter term loan instead of the 7 year loan (Rs) 68,628 34,836 -
    Note: The above table is illustrative
    (Source: PersonalFN Research).

  7. What if the loan cannot be repaid? Well, lenders will come knocking at your door....and it can be a rather harrowing and embarrassing experience. So, get in touch with the borrower when the repayment schedule is skipped. Ignoring the communications will only make the measures severe and go on to impact your credit score.
  8. Make sure to pay off the debt with the highest interest rate first: In a world accustomed to plastic money, a growing credit card debt is a huge problem. Credit cards charge the highest interest rate. If you are unable to repay the entire credit card debt for a month, pay as much as you can and carry forward the minimum possible amount. The moment you carry forward your payment to the next monthly cycle, you will have to pay interest on the unpaid amount along with taxes - and this is a very expensive in the long run.
  9. Besides, the above also look into the follow facets...

  10. Have you accounted for Emergencies? Life isn't all white and black. There are grey shades too. It is a prudent practice to account for 6 months to 24 months of regular monthly expenses (including EMI on loans). This will provide some cushion in case of loss of job, medical emergency, or any unfortunate event that comes when it's most unexpected and has a bearing on our financial health.
  11. Have you addressed the "What if" question: Well, bereavement is a topic ignored by most households. "It won't happen to me" is the misconception that many live by. But, every bread winner of the family has to honestly address this question. For long term loans (such as home loans), lenders make it compulsory for the borrower to purchase a reducing term insurance policy and assign it in favour of the lender. The objective is to protect the financial interest of the lender and the family, in case of an untoward incidence faced by the borrower. Remember, insurance is a contract of indemnification and hence should be not be ignored.
  12. Saving for golden years: When you borrow - and especially when you're over-leveraged - the question you need to ask yourself: Am I compromising on my retirement funds. As per the survey conducted by Willis Towers Watson, more than 51% individuals from the Asia Pacific region, believed, they were worse off in retirement than their parents. So while may borrow, ensure that it's not overdone whereby vital long-term financial goals are sabotaged.

To Conclude...

Increasingly, banks have become cautious and are adopting rigorous credit checks (by obtaining credit information reports from credit bureaus). So when you borrower, stretch within means so to keep your financial health in pink and to avoid the nightmares later.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


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