DSIJ Mindshare

Loans: The Noose Around Your Neck

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Case 1: Amit Tiwari, working as a marketing manager with a top media company, was recently shell-shocked to receive a call from his credit card company’s collection department. In a very hostile manner he was told that he had defaulted in the payment of dues accumulated against his card and that he owed Rs 1 lakh to the company. In fact, he was also warned in no uncertain terms that he would be hauled off to the court if he did not cough up the dues immediately.

Quite perplexed with the situation, Amit tried quite a number of options but failed to obtain the needed funds to come out of this mess. That’s when he did what most people do when pushed into a corner. He applied for another credit card with a limit of Rs 1 lakh to pay the dues of the first one. He managed to temporarily resolve the problem but now his outstanding payments for the second card have already crossed Rs 1.80 lakhs and with just Rs 30,000 per month as his take-home salary, Tiwari is at his wit’s end in trying to clear this financial mess.

Case 2: Top IT executive Rohan Singh (name changed) was always one of those astute investors, judiciously building his portfolio and making sure that it was well-diversified with a wide range of products. Till the end of 2007 he was considered one of the best managers of surplus funds among his colleagues. However, this planned approach went for a total toss during the meltdown phase. What happened was that with a take-home salary of  Rs 1.10 lakhs per month he purchased a house for him-self and then booked another flat at a price of  Rs 30 lakhs in an already booming market in mid-2007. The gross price of these houses totalled Rs 75 lakhs for which he had taken an aggregate loan of Rs 55 lakhs at 11 per cent floating interest on which he was paying EMIs of around Rs 75,500 per month.

Everything sailed smoothly for many months but the real problem started when the financial meltdown hit the globe. The IT sector was among those that faced the primary brunt and Rohan’s salary was slashed by a whopping 20 per cent that brought his take-home down to Rs 88,000. Now after deducting Rs 75,500 of EMIs (equated monthly installments) he was left with just Rs 12,500 per month while his monthly expenses worked out to Rs 30,000. Surely he was in a trap. Left with no option he decided to sell the second house but in a lean market the value he got was just Rs 22 lakhs, implying a clear loss of Rs 8 lakhs.

These two cases are perfect examples of a situation generally termed as a ‘debt trap’ wherein the income of a person falls short of his out-flows and he/she finds himself in a situation that is traumatic both in the financial [PAGE BREAK]

as well as the emotional sense. But have you noticed the peculiarities about these two cases? The first one is certainly the outcome of an extravagant and reckless attitude that made Tiwari depend too much on plastic money even though his income didn’t support it. In the second case, the trap wasn’t due to any carelessness on the part of Singh. It was more to do with the bad timing of the decisions and his failure to foresee future contingencies.

That is something DSIJ strives to address through this column. You can be the next one to be trapped in this vicious spiral. So beware! Always keep in mind that in this materialistic world there is no such thing as free lunch and easily accessible credits and loans are especially designed to lure you into this dangerous cul-de-sac. Therefore, it is up to you to either use such facilities wisely and with care or else simply avoid them altogether.

How Much Is Enough? 
There have been various kinds of deliberations among financial planners as to ‘how much debt is enough?’ Though experts have different methods and ways for reaching the magical limit, all of them agree that it should be as less as it can be. “In my view, in any case a person’s EMI should not be more than 20 per cent of the take-home income and every individual should manage his or her debts accordingly,” says Kavi Arora, CEO, Religare Finvest, adding, “However, it depends from person to person and his/her income profile. This criterion can be stretched a little bit only in case of a housing loan.”

This criterion is very contradictory with the norms of banking companies who can easily finance any person up to an EMI amount of 50 per cent of his/her take-home salary. What is more disturbing in the present era of lenient financing is the fact that banks and financial companies provide loans to the extent that the gross EMIs gobble up to 60-70 per cent of the take-home salary. They are able to do so simply by clubbing the spouse’s income to the loan applicant and in many cases the second income is established only on the basis of forged documents. In such a scenario, temporarily it may look like an achievement on the part of the loan taker to clock a hefty sum but the truth is that he/she is heading for disaster.

Be very clear that it is very difficult for anybody to get out of this trap and it usually involves emotional trauma and insult for the whole family when banks and financial companies resort to the confiscation of property or file court cases to recover their loans. Therefore, nobody should depend on his/her future income while taking any kind of loan. The picture should be as realistic as possible. Also, as pointed out earlier, it is only in the case of a home loan that the EMI limit of 20 per cent of take-home should be breached. Another vital factor is that of cash flows. Plan any debt according to your inflows and monthly expenses. It is often observed that people splurge a lot on enjoyment, accessories, and shopping without taking into account the loan repayment factor. Also, in the present era of the economy risk of a spiralling interest rate, things can turn from bad to worse in a jiffy.[PAGE BREAK]

Is Your Loan A ‘Necessity’?
Conventionally India has always been a ‘saving society’ and according to the available official data we usually save 35 per cent of the income. So we already have an inherent culture of spending judiciously. The financial meltdown in the recent past has also proved that this is the best practice and overleveraging can have various serious repercussions. Taking a cue from the past it is very crucial that we should try to avoid any kind of loan as far as possible. As Vijay Agarwal, VP and Head-Product & Investment Advisory, Unicon Investment Solutions, puts it, “A loan should certainly be a last mile effort when it comes to arranging for finance. A person should resort to taking a loan when it becomes a necessity rather than a luxury. A loan should never be taken just because it is too easy to get one.”

“Nothing comes free and that applies in good measure for loans. As a thumb rule, loans should only be taken to create assets and should always be avoided for meeting expenses,” he adds. The reasoning is simple: if anybody takes a loan for purchasing a house then in that case he/she is paying EMIs for the creation of an asset that will provide good value in the future. At the same time if that loan is spent on petty expenditure then he/she has to keep paying for the next several months or years for the benefits and enjoyments experienced at present. Therefore, loans for personal use or buying automobiles should generally be avoided. So also credit cards since the rate of interest is almost always steep as these loans are categorised as ‘unsecured’.

Are You Heading For Trouble?
Though we all are fully aware of the aftermaths of a debt trap, yet it is very difficult for anybody to perceive that he/she is heading towards a situation of financial turmoil. Financial planners do suggest various rules and indicators that can give you quite a clear picture so as to foresee the problems and also avoid them. These include:

  • If you are not able to meet your expenses till the end of the month then it is a clear indicator that something is going wrong.
  • In any month if your outflows surpass the inflows due to some contingency then it is a clear indicator that you are at the edge of getting trapped.
  • If your EMIs, including housing loan EMI, crosses the threshold of 40 per cent of the take-home salary then beware. A debt trap may be right in front of you.[PAGE BREAK]
  • Avoid taking a loan in an inflationary economy because a rise in interest rate is almost certain and with every percentage point increase in the rate your EMI will shoot up by more than 2 per cent.
  • After already being a housing and auto loan taker, if you have to resort to personal loan to meet any unforeseen expenditure then it shows that you don’t have enough cushioning to support you.
  • If your general purpose loan EMIs account for more than 20 per cent of your take-home then it is time to re-think about these loans and credit cards.
  • Always give due importance to cash inflows and outflows rather than income generation.

Hierarchy Of Loans
There exists a well-structured hierarchy for the loans as to which has to be taken first and which has to be treated as a last resort. There are some loans that should be avoided at all costs. It goes like this:

Housing Loan: The best loan product is a housing loan that not only helps you to create an asset but also works as forced saving and a tax-saving instrument.

Loan Against Property: After a housing loan if at all you need funds for any kind of emergency then you can look upon taking a loan against property. This loan is quite helpful as it bears a low interest rate and the EMIs of it can be clubbed with your housing loan.

Loan Against Securities/Fixed Deposits: This again is a low interest loan that can be resorted to emergencies like medical treatment, children’s education, etc. Another benefit of this loan is that it is long-term in nature as in the case of NSCs or KVPs which are usually of more than five years so that the loan taker has enough breathing space.

Education Loan: This is a decent loan for education purposes with low interest rate and long pay-back period.

Auto Loan: This should be taken with caution as it is a high interest loan. The down payment for such a loan should be as high as possible, thereby reducing the loan amount. Also, if not required, this loan should be avoided. And if you must take this loan, choose an economical model of the vehicle.

Personal Loan: It should certainly be a last mile effort and only when the acute urgency of the situation warrants it. Efforts should be made to get rid of it as soon as possible. Don’t take this loan for any luxury.[PAGE BREAK]

Credit Card: Don’t become addicted to the use of a credit card and as far as possible curtail your expenses to stay within the limits of your income. Don’t ever carry more than one card as it is a liability and not an asset.

Loan From Moneylenders: It is not at all advisable to take a loan from any unorganised lender as the interest rate of such a loan can be as high as 50 per cent per year and carries the risk of making you lose your entire wealth and peace of mind.

Are You In A State Of Panic?
In spite of all your efforts and using your wisdom if, by any reason, you find yourself trapped in a debt mess the most important thing that you should remember is that it is only you and your family’s efforts that can enable you to get out of it. So the ‘guru mantra’ in such a situation is not to panic and share this problem with your family. “In a majority of the cases people usually hide their financial situation from their family members and in this process of hiding they pitch for newer loans to pay the older ones and that drags them into the whirlpool of financial mismanagement,” points out a senior official of IDBI Bank. “In such a scenario, consultation is the best way out as the family can cut down the collective expenditure to reduce the burden,” he adds.

Also, first make a list of your loans and their monthly EMIs. “This will give the person a clear perspective of his/her liabilities and he/she should try to arrange for funds so that the liabilities towards personal loans and credit cards can be met at the earliest as these are high interest-bearing products. In this effort some smaller assets can be cashed to meet these liabilities so that the person gets some breathing space,” Arora suggests.  Going to a bank to restructure the loan is also a viable option. “You should keep in mind that personal loan, credit cards, etc. are unsecured loans and therefore the borrower has to pay interest to the tune of 20-25 per cent while secured loans like loan against property or government securities like National Saving Certificate, Kisan Vikas Patra (KVP), or LIC policy can be taken at 12-13 per cent,” he adds.

“A person can always approach the bank for restructuring his/her loan from an high interest instrument to one of low interest by mortgaging any particular security and briefing them about his financial situation. This will ease the burden greatly as banks also don’t want to make their loans turn irrecoverable,” Agarwal states. Once this step is taken, a person must explore all the possible options of adding to his/her monthly income on the one hand and cutting down the expenses on the other. This should be enough to provide sufficient scope for anybody to get out of a vicious debt trap.

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