Resist buying temptation to avoid a debt trap

Just bought a new car with a loan and a flat screen TV with your credit card? Resist the temptation to now buy that high-end home theatre system till your bank balance recuperates! Excess debt can be a sticky situation, where you might begin borrowing more money to repay old loans. This vicious cycle might ultimately result in default.

Credit card cutbacks

The leading cause of financial stress for a normal household is often a credit card, or many such cards. The important thing to do when you land up with a huge bill is to pay it off as soon as possible to prevent interest from piling up.

For example, say you have a credit card bill of Rs 50,000 and the interest rate is 3 per cent a month. Based on the interest that would accrue to this sum, if you choose to make only a minimum payment of Rs 1,500 every month, it would take you 120 months to clear the loan.

To boot, the interest you would pay would be two-and-a-half times the value of the original purchase at Rs 1,29,450. With a Rs 3,000 a month payment, the bill would be cleared in 22 months. What is more, the interest paid would reduce to Rs 17,447.

So the earlier you clear the bill, the less you have to pay toward interest as well. You should also remember that when you have an outstanding amount on your credit card bill, future purchases will not be given an interest-free grace period.

Home loans

Buying a home is a dream for most Indians, but you have to remember not to bite off more than you can chew when taking a loan. In this respect, the amount taken as loan and the tenure are factors that could make buying a home either a dream or a nightmare.

Lenders may permit loan amounts that take up 45-60 per cent of your gross salary, but this rule of thumb may have to be tempered by many factors. If you have many dependents, expect no growth in pay or have other liabilities, you will need to keep your EMI much lower than the eligibility criteria permit.

While a longer tenure loan will enable you to pay smaller sums over a longer period of time, a shorter duration will reduce your interest expenses. For example, for a loan for Rs 10 lakh with a tenure of four years, the EMI outflow would work out to Rs 25,300. This includes payment of total interest amounting to Rs 2,14,400.

On the other hand, if the tenure of the loan was 20 years, the EMI outflow works out to a more manageable Rs 9,600.

However, the amount of interest you would be paying over and above the principal amount would be Rs 13,04,000 – more than double the loan.

It makes sense to go for a longer tenure loan to keep your EMI payments manageable, but at the same time, utilise opportunities such as a salary bonus or gratuity to pre-pay or make partial pre-payment of the loan so that interest outgo is minimised.

Make sure that your home loan provider does not charge a penalty for pre-payment.

Save up for emergencies

It is more often unplanned expenses that land you in a debt trap. For example, a medical emergency involving a member of the family can drain your bank account within days, putting a question mark over the servicing of existing liabilities and may drive you to borrow more to tide over in a difficult period, landing you in a debt trap. Or suppose you lose your job and have to live on your savings till you find your feet again.

When the going is good, it’s important to put your money to work for you beyond the low interest rate earned from a bank account. An emergency fund should generally amount to 6 months’ living expenses. It must be invested in a safe avenue such as a fund that can be liquidated quickly.

By shifting small sums from your savings account to a recurring deposit every month too, you can establish a tidy sum for a rainy day. If you have too much money in your savings account, you could perhaps go in for the ‘sweep’ facility offered by many banks.

Don’t borrow for consumption

Learn to draw the line at taking loans that are merely intended to finance consumption.

Taking a loan to go on a foreign holiday makes less sense than a loan for a property purchase. Ideally, a loan should be taken for the purpose of creating an asset, which will appreciate in value over time. While buying an LCD TV or a refrigerator on a loan is not necessarily a bad idea, the value of these consumer items erodes over time and at the end of their lifecycle, they have little resale value.

> arvind.jayaram@thehindu.co.in

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