Debt: Let it go!

Today, there are three kinds of people: “the haves, the have-nots, and the have-not-paid-for-what-they-haves.” -Earl Wilson

Borrowing allows a person to consume beyond their level of capacity. However, nobody can borrow for an indefinite period of time since unsustainable levels of borrowing will land you in a debt crisis. If not managed properly, borrowings can become your crown of thorns. Have a look at some astonishing statistics in our own country. The total personal loans, at the end of March 2019, stood at a whopping Rs 22.21 lakh crore, 120% more than Rs 10.1 lakh crore in the corresponding quarter in 2014. As you can see, Indians’ borrowings have more than doubled in the last six years. It is quite alarming information for a developing country like ours as it indicates a                                                                                    substantial rise in the reliance of people on debt for living their lives.

DEBT AND YOUTH: A LOVE-HATE STORY

The cost of living has increased, leading to an increase in expenditure. However, there is no commensurate income growth. Interestingly, fulfilling family needs and their desires is the most important factor for people choosing to borrow a new loan. The second reason why most Indians are taking a loan is to improve their lifestyle. 

There has been a rise in unemployment, but those with employment as well have failed to see a growth in their income or employ efficient money management tactics for their financial wellness. Let’s understand this with the help of a story.

Kiara is an educated and employed young woman who makes a very good salary but has chronic spending problems. She never has enough money to last until her next paycheck and doesn’t have any satisfactory reasons as to where her money is spent. Kiara’s spending habits include Starbucks twice a day, two packs of cigarettes per week, eating out for lunch, impulsive shopping. Her spending habits resulted in her accumulating Rs. 5,00,000 in credit card debt. Upon reviewing her financial situation, it was clear that Kiara cannot realistically pay off all her debts. However, because she earns a good salary, she didn’t have to suffer from bankruptcy. She could offer her creditors a settlement, in the form of a monthly payment plan, and thereby changing her habits by making coffee at home, cutting down on vices, packing her lunch and setting a maximum budget for discretionary funds. 

Unfortunately, this is the story of a huge majority of youth in our country. An ET Wealth survey found that 15 percent of respondents had an EMI outgoing of more than 50% of their income.

The survey also showed that one in five respondents have taken loans to repay existing loans in the past year — a classic indicator of ‘debt refinancing’ which negatively impacts your credit score because the average age of your credit will go down. You must be aware of the fact that having a low credit score can cause significant challenges.

A job loss, a medical emergency, etc. can force one to borrow beyond one’s ability to repay. The circumstances could be positive and still might require borrowings. Education loan is one such example. 

WHO PLAYS THE CUPID IN THE LOVE-HATE STORY?

  • Banks/Credit Unions: Fixed loans are loans where the interest rate does not fluctuate whereas Variable loans are loans where the interest rate keeps on floating up and down over the time based on your credit score and history. For more information on Credit score refer to our blogWith great credit comes great credibility.’ Examples are student loans, mortgages, auto loans, personal loans, small business loans. 
  • Asset-based lending is any kind of lending secured by an asset, ie. if the loan is not repaid, the asset is confiscated. Example: mortgage
  • Peer-to-peer lenders: Borrowing from individuals, through online organizations that match lenders with borrowers
  • Relatives and friends: Some institutions help sort out the tricky financial and personal issues involved with these transactions. If you are considering a loan from someone you know, be sure to create a loan agreement or you’ll spoil your relationships.

GOOD DEBT VS BAD DEBT: Although living completely debt-free is possible, it isn’t necessarily smart. Very few people have enough money to pay for important things in life: a home, a car or college education. Even though debts can pile up quickly, a well-maintained one will be good as long as you repay it timely and it may even lead to a higher income potential in the future. When buying on credit or taking out a loan, the most significant factor is whether the debt is good or bad.

Good debt is an investment that will grow in value or generate long-term income. If you buy a rental home by raising a loan and the expenses are paid for by the rents, then that is good debt. Your goal needs to be positive cash flow.

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also a debt that carries a high interest rate, like credit card debt. 

DEBT MANAGEMENT STRATEGIES:

DEBT AVALANCHE/WATERFALL METHOD: All you mathematical wizards, this is your finger-licking pie. You swallow the debt with the highest interest rate first, as it is costing you the most. Suppose, this is your list of debts:   

A)  Car loan

Rs. 1,50,000

@10.5%

B) Credit Card 1

Rs. 1,50,000

@38%

C) Credit Card 2

Rs. 45,000

@36%

D) Student Loan

Rs. 5,00,000

@14.25%

Using the above method, you will focus on repaying debt B, C, D, A- ranked in order of interest rate payouts. Hence, any additional funds will go towards paying off Credit Card 1 in addition to paying the minimum on the rest of your debt. Here, the loan size or balances aren’t taken into consideration.

DEBT SNOWBALL METHOD: This is your mumbo-jumbo taking precedence, it helps in winning the all-odds-stacked-against-you situations. Pick your smallest pie first. Target the loan with the lowest balance and hit your first swift win. This will motivate you to pay your next target and raise your momentum of repayment. Using the above example: target (C) followed by (A) and (B) respectively and finally the big fat (D). The debt repayment would snowball into something bigger with each repaid debt and your worries are going to head further away from you. #Acceleration impact!

No one can generalise whether a debt is good or bad. It is not the debt that’s bad, it’s the repayment which makes it good or bad. Jesus was able to make bread and wine to feed the masses. You probably can’t do that, but you can make your savings proliferate by wisely investing. Once you’ve made up your mind to reduce your debt, the first thing to do is to stop taking new loans unnecessarily. The next step is to reduce your spending and limiting them to necessary things- no splurging! You need to become skilled at making, controlling and safeguarding your money. 

Team Investoday