Kill your bad debt before it kills you

Debt has traditionally been considered bad. And it isn’t without reason. In the olden days, institutional lending was scarce and interest rates were exorbitant. Usurers thrived in such times.

With income levels rising and access to loans becoming easier, debt has now gained more social acceptance. Loans fund the comforts and luxuries of life for many. It is hard to find a white-collar worker without a debt obligation.

But, with the economy now on a downturn, pink slips more frequent than ever and incomes stagnating, borrowers realise that loan commitments are an albatross around their necks. Rising inflation is adding to their worries -- last November, the consumer food price inflation touched 10.01 per cent year-on-year. Returns from traditional savings tools such as bank deposits are at multi-year lows.

As a consequence, the personal finance of salaried persons has taken a big hit. For some, investment plans have gone awry. Some others are struggling to pay their EMIs. Yet others find themselves in a debt trap. All blame it on the loans they have availed of. It isn’t surprising, given the low credit literacy rate in the country. But it is never too late to tackle this challenge.

‘Toxic’ debt

“Debt is a dual-edged sword,” says Shreenivas Kunte, Director of Continuing Education and Advocacy, CFA Institute. It can be a tool for accumulating wealth, but loan cycles one after another can be disastrous. “The basic principle to follow is to borrow what you can afford to pay back and be disciplined when it comes to repayment,” says Saurav Basu, Head, Wealth Management, Tata Capital.

Debt per se may not be bad, but certain types of debt are toxic. One example is credit card dues; unrestrained use of multiple credit cards is a sure recipe for disaster. Gaurav Chopra, founder and CEO of IndiaLends, says one particularly bad credit habit is procrastinating debt repayment. Overspending on luxuries is another trait that can land you in a vicious debt cycle, he warns. Paying the minimum amount due on the credit card and rolling over the debt is another habit widely in practice. “This way, one ends up paying heavy interest…One should never be in such a situation,” says Basu.

Kunte agrees. “Unpaid credit debt can carry high interest. It could be as high as 3 per cent per month,” he says, adding that fast depreciating assets, such as mobile phones, are not a good reason to take debt.

Personal loan is another example of bad debt. This non-collateral credit comes with no strings attached to spending of money borrowed. But personal finance advisers say you don’t need to acquire high-cost debt for holidaying, as such a purpose can be met with prior planning, disciplined savings and careful investments.

A borrower who wishes to remain anonymous says he was a victim of the persuasive power of lenders. Consistent calls from loan agents made him change his mind and go for a long-planned family vacation on borrowed money. With the proverbial Damocles sword now hanging over his job, he rues the fact that he is locked in a three-year debt that charges 15 per cent interest.

Medical exigencies are often cited as a valid reason for obtaining a personal loan. Today, insurance products cover even serious, life-threatening diseases such as cancer that can drain even deep pockets. An insurance customer who underwent a surgery a couple of years ago says: “It is still okay to pay 20-25 per cent from your pocket and the rest through insurance for the medical bill that runs into lakhs of rupees even for a minor ailment.” Sufficient health insurance cover is a good shield against debt. The key here is buying insurance cover early in your life to avoid higher premium. It is unfortunate if one exhausts the sufficient health cover and needs to go for a loan to meet treatment costs.

Signs of loan trap

Defaulting on repayments, whether credit card dues or home loan EMIs, is an early sign of landing in a debt trap. Once defaulted, it becomes a herculean task to get back on track. The reasons for defaults are many, the main ones being job-loss and delayed salaries. Still worse, borrowers don’t have control over factors such as retrenchment. As Kunte says, a debt trap can dry up the sources of bank and legal funding, and may drive a debtor to access funding from doubtful sources.

Two categories of debtors need to be careful. “The first category has enough access to money but are careless. The second category does not have access to money...The second is where there is a heightened risk of a debt trap,” says Kunte.

When your EMIs are more than half of your monthly income, you can expect to land in a trap sooner than later, says IndiaLends’ Chopra, who is also President of the Digital Lenders Association of India.

No plan perfectly cushions the debt burden in the case of regular defaults. The best safety net against a loan trap is a clear-cut understanding of the debt, its use and how it works. As Kunte says, regardless of age and gender, a borrower needs to know whether the instrument is working for him/her or not.

Good debt

There are examples of good debt, too. Home loans are a case in point. Assets that are funded through debt but which hold the potential to become future sources of funds are good debt, says Kunte.

“As a working professional, if you plan to buy a house and your income level (gives you the comfort) to invest in a house, then a smart home loan with a disciplined repayment plan can help build a good asset,” says Tata Capital’s Basu, adding that when property prices appreciate, it can help build more value and, in effect, create wealth in the form of an asset.

“Taking debt for one’s own education or that of a child is a good use of debt. In general, the more educated one is, the higher the likelihood of better wealth creation,” points out Kunte.

However, initiating children into the world of debt is a debatable point with many parents and even bankers.

Take an unwise step or be a little indiscreet in your borrowings, and you have an elephant in the room. Even good debt calls for deft handling.

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