DEBT Management :The Way Out Of Your Financial Troubles

Debts taken for funding and backing investments like house, capital for starting business, educating children, etc. is good debt. Nevertheless, the problem sets in when you use debt to finance a depreciating asset to improve your standard of living with an additional cost burden that is more than you can afford. So how can you avoid getting trapped in the vicious circle of debt repayments? The article lays out the various options

Nowadays, with the hype for lavish lifestyle and easily available credit, people have developed a tendency to acquire loans or get burdened with debt. This debt either is not required or is not sustainable with their current income sources. Such a debt burden can hamper one’s financials in scenarios where the person’s income stops for any reason or fluctuates. Therefore, one should carefully and vigilantly manage and take debts. Debt is not necessarily always bad for the financial health of an individual. At times, there can be a compelling reason for availing debt. In fact, access to debt in moderation is good.

Debts taken for funding and backing investments like house, capital for starting business, educating children, etc. is good debt. Nevertheless, the problem sets in when you use debt to finance a depreciating asset to improve your standard of living with an additional cost burden that is more than you can afford. This is particularly true about millennial who usually get carried away with their desire to own new things and forget to think about the income they earn and expenses they must indulge in.

Defining Debt
What does debt actually mean? Debt is the amount of money borrowed by one party from another in order to fund oneself. Essentially individuals utilise debt as a method for funding large purchases that they cannot afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. With increasing acquisitiveness in these times, everyone seems to be in a race to have too much too soon. This often leads to people exploiting their current income and resources beyond capacity and spending more than they can afford to. Debt has become a fact of life for many these days and a certain amount of debt is normal and not always financially unhealthy if it can be managed well. However, some people cannot repay their debts, creating a damaging cycle of borrowing known as a debt trap.

The Debt Trap
A debt trap is a situation in which an individual borrows money but does not have enough money to make interest payments on the loan or debt and so takes another loan with its own interest payments to cover the first loan payment. They will not able to pay these interest payments and just get stuck into a cycle and get trapped into it. Technically, it is situation where the amount of debt you owe spirals out of control. Generally, a debt trap will result in default of payments or bankruptcy.

Emerging from a Debt Trap
One should in normal circumstances refrain from taking debt for buying things which can be consumed quickly. The key is to make the debt work for you and not against you. The need for debt can be managed by effective budgeting, wherein the income and expense of an individual is matched and priori-tized. A simple definition of debt management is the practice of spending less than you make. For most purposes, debt manage-ment is defined as the structuring of a repayment plan.

• Cut down on variable spending and put the extra money towards debt repayment so that you can pay off your debts early and get debt-free.
• Priority of repayment should be given to debts with the highest interest rate. Once the debt with highest rate is wiped out, allocate money towards paying debt with the next highest rate and so on.
• For majority of people, curbing in discretionary spending for few months goes a long way towards tackling debt. But if that’s not enough, try to cut down fixed expenses. Take required steps to lower household bills and refinance mortgage to get lower interest rate.

One of the options for an individual to pay off all his debts is debt consolidation, which is a form of debt refinancing that involves taking out one loan to pay off many other small loans. In this process, all your outstanding balances of loan or debt can get consolidated into single monthly payment in the form of personal loan. Basically, debt consolidation is used by consumers to pay off a small debt in one go by taking a bigger loan. By doing this you can manage liquidity in a better way. Now the borrower will have to make a single payment instead of several payments to various creditors. Debt consolidation can happen on debts which are not tied up to an asset.

Education loan, amount owed on credit card, personal loan are some examples of unsecured loans which can come under debt consolidation. Sometimes, trying to consolidate debt with bad credit score is not a great idea. If your credit rating is low it’s hard to get a low interest loan to consolidate debts. Nonetheless, debt consolidation with a high interest loan can make your financial situation worse instead of better. The following table highlights banks offering interest rates on debt consolidation loans

For instance, consider an individual with a total loan obligation of Rs5,00,000 which includes a two-year loan of Rs2,00,000 with an interest rate of 11 per cent. And he has two other loans amounting to Rs2,00,000 and Rs1,00,000 for the tenure of two years and one year, respectively, at the rate of 10 per cent and 12.5 per cent annually. The monthly payments for all the three loans works out to Rs27,458 which includes a payment of Rs9,321 from the first loan, Rs9,228 from the second loan and Rs8,908 from the third loan. Now suppose this individual approaches a consolidation company in order to consolidate all his loans. Let’s say he approaches Citibank for a personal loan. If all his debts get consolidated, he will have to pay 11.25 per cent on Rs5,00,000 for a period of, say, five years.

Then he will pay Rs10,933 per month instead of Rs27,458 every month that he was paying earlier. As can be seen, a sufficient amount of his EMI has been reduced. In this way debt consoli-dation of a loan can help an individual to lower his principal and interest outgo. Debt consolidation loan is better when the interest rate of such a loan is lower. Generally, debt consolida-tion loans offer interest rates from 11 per cent and onwards. A person should take a consolidation loan only if he saves on interest rate or it helps him to manage liquidity. Normally, consolidation loan varies between 11 per cent and 17 per cent. If the interest rate is too high compared to what he is paying currently, the individual might end up paying a large amount of EMIs and the actual essence of debt consolidation will get lost.

Continuing with the above example, the total outflow including interest and principal without loan consolidation was to the tune of Rs5,52,112 in three years and on the other hand the total outflow in case of consolidation will be Rs6,55,980 in five years. Therefore, it seems that the total cash outflow is more in case of consolidated debt loan and lower in case of the old loan pattern. This is obvious since the consolidated debt loan is for a longer tenure as compared to the previous three loans. Even though his total outflow is more in case of a consolidated debt loan, the person can manage monthly liquidity in a better way by paying lower EMIs as compared to the old loan pattern.

 Let’s understand how lower EMIs help in liquidity manage-ment. For example, if your salary is Rs40,000 then in case of the old loan pattern you were paying Rs27,458 as EMI i.e. almost 68.65 per cent of the salary was getting utilised towards debt repayment, thus leaving very little to take care of other basic expenses which may again lead you to take a further loan and get trapped into a debt cycle. Conversely, in case of a debt consolidation loan you are only paying Rs10,933 as an EMI i.e. only 27.33 per cent of your salary is getting utilised towards repayment of debt and therefore you have enough liquidity to fulfil your basic needs, thus not pushing you to take a further loan. This is how debt consolidation loan can help you come out of your debt trap.

Debt Management and Credit Score
What should an individual with poor credit score do in case he gets trapped in debt? Here’s one more option an individual has in case he wants to get out of the debt trap and free himself from any kind of debt. This is called the debt management program (DMP), which is a formal agreement between a debtor and creditor. DMP help reduce outstanding, unsecured debts at a reduced level over a fixed period of time to help regain control of finances. Debt management is strictly defined as the inclusion of a third party that helps a debtor repay his financial obligations. There are many companies that specialise in credit counselling and also offer debt management assistance for people whose credit score is poor and whose debts have gone out of control.

The agency helping to create such a debt management plan will aid you to figure out how much you can afford to pay on your debt each month. DMP is individually tailored based on what can be realistically afforded on a monthly basis. To achieve an accurate figure, an income and expenditure test will establish what monies are coming into the household and what is paid out. Income and expenditure include everything, such as rent, secured loans, utility bills and necessary living expenses. Once income and expenditure are complete, the remaining is your disposable income which is divided amongst the creditors through a debt management company. DMP will also negotiate with creditors on your behalf to help get you lower interest rates and monthly payments.

Four Main Categories of Debt

Secured Debt: Debt secured by collateral to reduce the risk associated with lending. If borrower defaults on repayment, the lender seizes your asset which is collateral and uses proceeds to pay back the debt

Mortgages: Mortgages are secured loans that are specifically tied to real estate property, such as land or house. The property is owned by the borrower in exchange for money that is paid in installments over time

Unsecured Debt: A loan not secured by an underlying asset or collateral. Unsecured debt is the opposite of secured debt. Unse-cured debt carries more risk for the lender, which in turn makes the loan more expensive.

Revolving Debt: Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit. In other words, the borrower may use funds up to a certain amount, pay it back, and borrow up to that amount again. The most common form of revolving debt is credit card debt

Refinancing
In refinancing an existing loan is paid off with proceeds from a new loan, usually of the same size and using the same propertyas collateral. The reasons why one should consider refinancing include:
• Lowering your interest rate. You may be able to lower the rate because of changes in market conditions.
• To adjust the length of your debt. Refinancing may be done to decrease or increase the tenure of the debt.
• Switching between a fixed rate and adjustable rate debt.

For instance, consider an individual who has taken a home loan of Rs30 lakhs with tenure of 25 years from PQR Ltd. The interest rate is floating at 11 per cent. Now after four years of taking the loan, the interest rate has fallen and he gets an offer of 10 per cent floating interest rate from MNO Ltd. So, if he refinances his loan for the remaining term then the processing fee charged by MNO is 0.5 per cent of the outstanding loan amount. He now has to decide whether to refinance his loan with MNO or continue unchanged with PQR.

1. Description of present loan from PQR Ltd.
• Loan amount = Rs30,00,000
• Interest rate = 11 per cent
• Tenure = 25 years
• EMI = Rs29,403

2. Description of refinancing loan from MNO Ltd.
• Loan amount = Rs28,85,880 (EMI already paid for four years i.e. this is the outstanding loan amount)
•Interest rate = 10 per cent
• Tenure = 21 years
• EMI = Rs27,438

Should an individual refinance the home loan or continue with the current one?
•The total amount likely to be paid to PQR if he continues with the loan (a) = Rs74,09,656
• Total amount likely to be paid to MNO if he refinances the loan (b) = Rs69,14,467
• Savings (c) = (a)-(b) = Rs4,95,189
• Less: Processing fees to MNO (d) = Rs14,429 (0.5 per cent of Rs28,85,880)
• Net Savings due to refinance: (c)-(d) = Rs4,80,760

From the above calculation it’s evident that the individual can save Rs4,80,760 after deducting the processing fee if he refinanc-es the loan from MNO Ltd. The above mentioned rates are for illustration purpose and are subject to change. Before taking a decision about refinancing, one should confirm the interest rate and various charges levied by banks.

Conclusion
To conclude, an individual should always take debt up to the limit that can be affordable, else he may end with a debt trap. In case anyone is saddled with a debt which he isn’t able to control, he can take help of the abovementioned options. Before opting for any of the options, you should understand the terms and conditions, interest rate offered and various charges. You should set up a proper budget, keep control over spending and take debts only for investments which are necessary to be funded. You should not take up unnecessary debt which you might not be able to repay and fall into the cycle of debt repayment for life.