How to circumvent a Debt-trap

 

 

Jayant R. Pai,

Renowned Financial Expert and CFPCM

Today, the pursuit of material wealth is no longer a passion confined to hedonists; it has become a national obsession. Members of the Indian middle-income segment are vying with each other to show off their microwaves, fully automatic washing machines and DVD players. Expensive foreign holidays, weekly visits to expensive restaurants, etc. have also become commonplace. ‘Instant gratification’ is the mantra chanted by many consumers.

So how do these consumers finance the purchase of such goodies? By working hard and saving more? "Oh No! That is too old fashioned." They prefer ‘Credit Cards’ and ‘Personal Loans’ route to achieve their dreams. I term these products, “Weapons of Mass Destruction” which have the potential to destroy borrowers by forcing them into a debt-trap.

What is a Debt-Trap? I define it as a situation wherein interest payments and principal repayments take up increasing amounts of our present and future income, consequently impairing our ability to meet other important expenses and ultimately paving the way to bankruptcy.

How does one fall into a debt-trap? The main causes are:

Unlimited desires and limited income.

Injudicious use of various credit products on offer.

How can one be vigilant in these matters? Here are some factors to look out for:

In the case of credit cards:

Banks advertise that you can enjoy fifty days of interest-free credit. However, this is not so. The fifty day period commences from the first day of the billing cycle and not from the date of purchases undertaken on the card. Hence know your Billing cycle and time your purchases accordingly.

Your credit card statement will state a certain minimum amount payable by the due date (usually 5% of the amount). Only the fine print will state that the outstanding balance will attract heavy interest of around 36-42% p.a. which is the highest interest rate amongst the various credit products. Worse, any further purchases made from the next cycle onwards will attract the same quantum of interest from day one and not from the end of that particular cycle. Also, many banks offer to automatically convert your purchases into Equated Monthly Instalments (EMIs) at zero or low interest rates. However once you account for hidden costs, the actual interest rate shoots up. Remember, there is no such animal as a Zero Interest EMI. The best option to prevent yourself from falling prey to such tactics is to pay the outstanding amount in full before the due date.

The cash advance facility offered by cards is a very expensive form of credit. Avoid it as far as possible.

The attractiveness of personal loans lies in the fact that they are easily available, often just on the basis of your salary slip. They usually do not require any collateral to be handed over to the bank and the end use of the money borrowed, is not monitored. Thus we may feel the inclination to opt for such a loan. In order to avoid any resultant debt-trap, ensure that: The cost of servicing such debt does not exceed 10-12% of your monthly income.

Such loans are not taken for frivolous purposes such as holidays. Remember, the interest rate on such loans of 18% plus is not low.

However, it is worth mentioning that it may be worthwhile to take such loans for the purpose of retiring higher-cost credit card debts. Such refinancing is beneficial in the longer run.

The “Home Loans/Mortgage” space is another area which has the potential to cause considerable havoc. Sharply falling rates in the past few years has induced many people to opt for such loans in the belief that they are borrowing to create an asset. However, indiscriminate borrowing only creates an onerous liability which can derail the best laid plans. This could be prevented by:

- First determining the amount of EMI which you can afford and then deciding on the quantum of borrowing. Mortgage EMI payments should ideally not exceed 35% of monthly income. This figure should be lower, in case our income source is not very stable.

- Desist from borrowing for a second home unless one has matching cash flows from rental receipts to offset the EMIs and maintenance charges.

- Prefer a fixed rate loan to a floating rate loan at least in the present economic scenario. This helps us in long range planning as our liability is known at the outset itself.