(by Sanjeev Kumar Gopalakrishnan)
Imagine that you have a sweet tooth and have a continuous yearning for the Rosogola or Jalebi. What would happen if you end up eating half-a-kilogram of each of these at one go? The chances are that you require medical attention for indigestion or something worse. Well, the outcome would be pretty much similar if one takes numerous loans.
Having said so, loans aren’t a disease. They’re actually very sound financial instruments to create assets without burning a hole in one’s wallet. Be it a vehicle, a house or even something more mundane that is required at home, acquiring each of these via deferred payments coming at an acceptable cost is a better option than spending upfront.
The challenge is to be constantly aware of the dept trap that’s just around the corner. This is a situation where one is unable to repay existing loans from one’s income and therefore has to borrow again.
Let’s take the example of the Kumars who have a family income of Rs.50,000 a month. The due recently took a home loan of Rs.20 lacs for seven years that fetched an EMI of Rs.31,673 at an interest of 8.5% per annum. The family spends an average Rs.10,000 a month on home needs while Mr. Kumar also has a bike loan whereby he pays Rs.7,752 a month. Mrs Kumar entered a chit fund that costs Rs.3,000 a month, thus resulting in a monthly shortfall of Rs.2,425 which has to be funded through borrowings from family and friends.
This proves that even families that do not fall under the definition of spendthrifts could end up in a debt trap. Imagine how things can worsen if one of the two earning members were to fall ill? This is where planning becomes important. By extending the repayment term, the Kumars could have reduced the home loan outgo per month and thus avoid borrowings.
The Debt Trap
The interest rates can make a big difference in your borrowing ability as well as repayment period. Suppose you have Rs.1 lac as credit card balance. The interest will be about 3.5% per month and with service tax it will be about 4% per month. This means that the annual interest rate will be about 48%! If you are paying just the minimum requirement of 5% of the outstanding amount every month, in the next 12 months you will paying interest of about Rs.46,000.
Similar is the case of personal loans and consumer loans. Such loans are usually not taken to acquire assets. These are often taken to pay for impulse purchases, like acquiring the new television, a mobile phone or other household goods.
The Great Escape
A best practice for using these acquisitions is to retain them till the cost of maintenance is equal to buying a new one! This way, one can also plan out the approximate time for the next purchase of these items. Accordingly set aside an amount every month in a bank account so that you can use it to buy these on the dates you have planned. This will help you to avoid short term consumer loans and credit card debts. It will also avoid impulse purchases.
Immediate Next Steps
Set aside an amount equal to your three months’ expenses and loan payments in a bank account as an emergency fund. In case of any unforeseen circumstances this will help you avoid borrowing. You can replace the amount taken over the next 12 months.
Life is unpredictable. Certain untoward incidences can push one into debt trap. Ensure that you have medical insurance for yourself and family so that you will not have to borrow to pay or jeopardise your savings plans. Ensuring ample life insurance to cover your loans so that they protect your family from falling into debt trap in your absence.
Do not be taken in by the credit reports that companies provide. Only you can figure how much you are worth and more importantly how much of that you can afford. Ideally your total loan repayments including the bided chit payments should not exceed 35 to 40% of your income. If you structure your loans and maintain a discipline in spending, you will be able to contain your loan payments within this limit.
Preparing a financial plan early in life will help you understand the financial needs over your life time. This helps you to understand how much you can spend and how much you should save to meet your life goals. It will help you to control the urge for instant gratification ignited by the in-your-face marketing campaigns of the day.
(About the author: Sanjeev Kumar Gopalakrishnan is the CEO of PrognoAdvisor.com, a SEBI registered investment advisory company that provides financial planning assistance to individuals. For specific advise or suggestions please write to Sanjeev@prognoadvisor.com)