ADITYA PARIKH says fast and easy loans have lead many into the debt trap. He gives simple solutions as well.
The word ‘binge’ is conventionally used in the context of food or alcohol. But today’s personal debt market has successfully introduced the word ‘binge’ into the financial lexicon. Credit cards, home loans, car loans, personal loans and the like, have provided a mouth watering, all you can eat buffet to the consumer. And stealthily, this binge is leading to a catastrophic financial indigestion that no antacid can cure. Borrowing from the adage, the only cure is prevention.
Conservative and debt have to be used in the same sentence, always. The 2008 economic meltdown owes its seeds to treating debt like the wild west- completely unfettered. And the results were for all to see – job losses, bankruptcies and all round gloom and doom. So, on a micro scale it is important to manage your debt, so you never slip into a personal economic meltdown. Personal debt, simply put, can be divided into two categories: the secured- one’s that are backed by assets like home loans, gold loans and car loans and the unsecured- one’s that are backed by no assets like credit card spends and personal loans
The balance between the two categories is essential or else, a recovery agent may be pounding on your door. The
secured category- the one backed with assets is naturally a less risky option for both the borrower and the lender due to the presence of collateral. However, assets are broad category, so deciding which asset to acquire with a loan is critical. In the unsecured category, personal loans and credit card spends, the risk factor multiplies due to the lack of collateral and tendency to overspend on unnecessary products. Three factors can assist the decision making process while dealing with personal debt- need and utility, affordability and asset price behaviour.
Need and utility is the primary factor. An EMI means that you have signed away part of your future income, therefore, prioritizing which assets to buy on EMI is critical to your financial health. Homes and cars naturally lie higher on the need and utility ladder, but flat screen TVs and fancy mobile phones are way down the ladder, if at all. Glossy marketing and easy credit has the spurred the growth of EMI led purchases of consumer electronics. Signing away one’s future income to a TV or a designer handbag is well, an ominous sign. The need quotient of assets and products is the first parameter to decide whether it’s a binge spend or a necessary one.
Asset price behaviour is not esoteric financial jargon. It has a real impact on your loan. Loans are usually given as percentage of asset price. For example, if you want to purchase a new home, banks would usually lend around 80% of the home value as loan. So, if the price of the asset you’re purchasing is volatile or depreciating, the stability of your loan can go for a toss. Depending on loan terms, banks can recall the loan, if they feel their security cover is reduced. So understanding asset price movements is important.
Residential property’s price behaviour is more stable than say, shares, making it usually a more stable asset to take a loan against. So typically, more stable and predictable the asset’s price movements, the higher the bank funding available, lower the interest rates and in the event of a loan default, better odds of the asset value covering the outstanding loan. A car though high on utility value, has an almost certain depreciation trajectory. When it comes to mobile phones, depreciation is a euphemism.
Affordability is the third and the ‘show me the money’ factor. This determines whether you will get a loan and how much. While dispensing loans, the general rule of thumb in the industry is that the EMI shouldn’t exceed around 50-60% of your monthly salary/income. And this includes all the EMIs of outstanding loans. This is an important figure, if you borrow to the limit, you will sign away 50% of your future income for the entire loan tenure. Home loans tenures are usually around 20 years, and that’s a long time. Also, once you have hit the limit, even in the times of emergency you may not get another loan and in case of a default, it would affect your CIBIL score making it difficult to get other loans.
Before taking a loan one should have a buffer strategy in place, for example, job losses can occur, so, if there are two earning members in the house, leverage only one’s salary. Also, calculate affordability backwards; deduct all household expenses, savings, insurance etc. from income to arrive at more realistic figure of what you can afford as an EMI. In any event, run any plan by your chartered accountant and financial planner for further safety.
Bingeing is all about buying stuff you don’t need, at prices you can’t afford and borrowing to do so. Lean is in, so cut the binge and keep that debt waistline in control.