Loan Management; A case study
Swapna will not forget 2014 December for a long time. That is the first time Rajesh took her and children for a holiday trip to Manali. Not only had that he also bought her silk saree and a gold necklace to wear during the marriage of her cousin during the same month. Till then whenever she tells Rajesh about going for a trip or buying sarees, he used to tell that home loan payment and car loan payments have to be made. So they should not be spending too much. What changed Rajesh’s mind was the expectation of getting a promotion and a salary hike. While 2014 December was a memorable month for Swapna, Rajesh gets shivers now when he thinks about that month.
Rajesh took a personal loan for Rs.2 lacs based on the expectation of salary hike. The EMI is about Rs.7230 for 36 months. He also had Rs.50000 in his bank account. He had a credit card with a limit of Rs.75000. He used to make the card payments in full every month. At the end of December 2014, his bank account balance was just Rs.4500, his credit card total dues were at Rs.74000 and the entire personal loan was spent.
In January he had to pay school fees of Rs.40000 for the 2 kids. His salary was Rs.70000. Out of that Rs.40000 was going as Home Loan and car EMI. Household expenses were Rs.20000 including the school fees which was paid on quarterly basis. He had a gold loan for which he was not making any repayments. His promotion did not happen soon. He got it after 6 months in June. By that time he has borrowed from all of his friends to cover the shortage every month. He is in a debt trap. From June onwards he is trying to repay the borrowings from friends. He is worried that he is not having any savings and has no bank balance to meet any adverse situation like falling sick.
Most of us are like Rajesh and Swapna. We want immediate gratification of our desires. We consider loans as bad as consuming loans. So when we have to take a loan, we want to repay it as fast as possible to get out of the obligation. We are more worried about the total interest we pay but we seldom care about our cash flows. Let us look into how we can avoid situation of debt trap.
- Avoid impulse purchases. Now a days TV channels, newspapers and internet is full of advertisements with mind boggling offers. Often we are lured into buying what we do not need or more than what we need. Before you go for shopping, prepare a list of things what you need to buy. Buy only those things even though you may find offers. Usually the offers will make you pay more than what you would have paid actually for the particular thing you needed.
- Avoid using credit cards. First you will think that you will repay the full amount every month and earn maximum points which you can redeem as gifts. Credit cards are easy source of money. So you tend to buy more goods. At the end of the month you may not be able to repay the full amount. The outstanding amount will carry huge interest cost of more than 40% per annum. Your trouble starts there.
- Avoid consumer loans. Now a day whether it is buying a TV or going for a Goa trip, you will get loans for which you have to pay monthly instalments only. So when offers rain during festival seasons, you tend to replace a TV bought 2 years back or a mobile phone bought one year back or an air conditioner. You should use the equipment to the fullest of its useful life. You can go for a consumer loan only if there is urgency.
- Manage your Spend. Ensure that all your loans put together, you will not be spending more than 40% of your income on loan repayments. If you want to take a higher home loan, then take it for a longer duration so that the EMI is low.
- Prepare a financial plan. A financial plan will ensure that you will have enough cash flow to meet your short term and long term needs. It will provide you a budget. It will tell you how much you should save for achieving your goals like children’s higher education and marriage, house construction and you retirement. Though you may not be able to gratify your desire like a holiday trip immediately, a financial plan can help you fulfil your desire after some time.
Now let us go back to Rajesh and Swapna and try to solve their problem. Their current situation is like this. Their total take home salary is about Rs.82000 per month. House hold expenses are about Rs.22000. Entire balance goes towards loan payments. The total loan outstanding is about Rs.25.03 lacs. The home loan was for Rs.25 lacs and for a period of 10 years. Now the home loan outstanding is Rs.17.96 lacs and 72 EMIs have to be paid. The current interest rate is 10.5%p.a. The house value is about Rs.40 lacs. They should take a top up loan for Rs.7.07 lacs and increase the repayment term to 120 months. Use the top up loan to repay the car loan, personal loan, gold loan and borrowing from friends. After that they will have a single loan with EMI of Rs.33774. They will have surplus of about 26 thousand rupees per month which they can save towards their goals in life.
The story of Rajesh and Swapna shows that it is possible to get out of debt trap by making some changes in the financials. The solution for the above story need not apply to another person’s situation. So let us look at the different ways in which one can get out of debt trap.
- Consolidate the loans and take a single loan by pledging collaterals. As the payment period can be longer and net interest rate will come down, the cash flows will become stronger.
- Start reducing expenses. Reducing expenses will help to increase money available for loan repayments.
- Identify additional income sources like part- time jobs. It will also increase the money available for loan repayments. If spouse is not working, she or he should try to take up some job to earn additional income.
- If the repayments are very high and it is difficult to increase the income, then sell some assets and repay the loans.
The above is the English transcript of the article published in the Mathrubhumi Grihalakshmi Magazine, Feb 2016 issue, written by Sanjeev Kumar G, Certified Financial Planner, Prognoadvisor.com