Does borrowing spell panic for you?

Source: The Economic Times.

Debt is no longer a dirty four letter word. It is the privilege of spending money you don’t have. Today, every financial institution is pushing consumer loans, home loans, car loans and credit cards aggressively. With the variety of loan products on offer, you can get easily swayed into taking on a loan. Borrowing has its own advantages, provided you know how to manage debt smartly. Let’s look at three real-life situations - being heavily in debt, not in debt but contemplating taking a large loan, and being averse to debt, and ways to emerge as a winner in each of these situations!

Being heavily in debt

Have you immersed yourself into too many loans? Juggling between a car loan, home loan and credit card bills? How will you know if you have slipped into a debt trap? Here are a few warning signs which will tell you if you have reached the ‘danger zone’ in your borrowings:

1. You have little or no savings left You simply pay the ‘minimum amount due’ on your credit card bills
2. A major portion of your monthly income goes towards paying off your debts
3. You borrow from other sources to pay your current dues
4. Your cheques have bounced a few times in the recent past

These are tell-tale signs that indicate how deeply you are stuck in debt. In such a scenario, the sooner you tighten your belt, the easier it will be to successfully shed the burden of debt. All you need is to get disciplined and follow a plan. Here’s how:

1. Prioritise your borrowings: If you are servicing many loans, the ones that should be cleared off first are the high interest rate loans and those with no tax benefits. Personal loans and credit cards fall into this category. Also, if you have taken a loan against any assets such as equity or house property, then this one too should be a priority, since if you are unable to repay on time, the financer can take hold of your assets. The loans that you can service over a period of time include home loans and education loans since these offer tax benefits and carry lower interest rates.
2. Take a low cost loan to pay off your high cost debts: If your existing loan comes with high interest costs, such as credit cards, you can consider taking a fresh low interest rate loan to settle high cost debts. For instance, taking a personal loan to repay your card outstandings makes sense since credit cards attract steeper interest rates than personal loans.
3. Dig into your own resources: If you are neck-deep in debt, you can encash your existing investments to pay off your loans. Investments bearing lower rates of return, such as fixed deposits, savings account balances, etc., can be withdrawn to clear off your dues. However, if your investments are earning good returns and repayments won’t be possible in a short time, it is best to leave these funds alone. If it’s a temporary bad patch, you could look at borrowing from friends and family to tide you over loan troubles, rather than touch your assets.
4. Curb your spending: One of the best ways to come out of the debt trap is to live moderately and prudently, cut down on unnecessary expenses, build up your savings and channelise your existing funds into repaying your high cost loans. Even if it entails living a frugal lifestyle for a while, do it.

Not in debt but contemplating taking a large loan

While borrowing comes with its own set of benefits, you need to consider the following factors before you take on a loan:

1. Borrow for a need, not a want: Before you take on debt, you need to understand it first. One kind of debt is the debt you incur to fund an expense, which can be called consumption debt, for instance, taking on a personal loan to buy some consumer durable. The second is investment debt, where you take a loan to build an asset, for example, taking a home loan. There are situations where you could avoid using credit, such as making impulsive purchases, meeting luxury expenses, etc.
2. Get the loan amount correct: Most financial experts suggest a maximum borrowing of up to 40-50 per cent of your total net monthly income. For instance, you should not take a home loan where the EMI exceeds 40-50 per cent of your net salary. Realistically speaking, how much credit you can afford solely depends on your own personal situation as well. If your current job is not very secure, the amount of credit should be less than this 40 per cent margin. Conversely , if your source of income is reliable and you have ample savings that are earning good returns, you may take more credit.
3. How much can you repay?: When you are repaying a loan, your monthly cash flow position changes. Knowing your repayment capacity before borrowing is important so that you can afford to pay your loan and continue to enjoy your current standard of living.

Being averse to debt

Avoiding debt altogether can actually prove unwise at times, since the power of credit is tremendous. Credit helps you achieve tangible aspirations and lets you build assets much earlier in life. Therefore, sometimes it makes sense to borrow. In fact, generally, major necessities such as buying a home or providing for education, merit borrowings. As a rule of thumb, if you are averse to the idea of debt, you may avoid borrowing for frivolous purposes like a vacation, apparel, dining out at expensive restaurants, speculating and gambling, etc. Sometimes borrowing is a close call. Items like furniture, appliances and certain home improvements fall into this category. It’s preferable not to borrow for such goods, but you may be able to justify the interest expense if you’re buying items that you’ll keep for 5-10 years or more.

Pull up your socks and act now

Sound financial advice doesn’t change much from year to year. Bad money management decisions, however, seem to mutate and flourish with each passing season. Managing your debt is in your hands. With just a week or two into the New Year, it isn’t too late to make that New Year resolution to get debt savvy!

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