Five steps to get out of high debt

There has been a sharp rise in household debt in India post-pandemic. The total household debt in India stood at 38 percent of GDP and 51 percent of net household disposable income in FY23, according to a recent report by Care Edge Ratings. While the household debt to GDP ratio improved from its peak of 39.2 percent in FY21, it continues to grow relative to net disposable income. The latter indicates a higher debt servicing burden for households. 

This has raised alarm bells and the Reserve Bank of India has tried to slow down the growth in unsecured credit such as loans for consumer durables, home appliances credit card loans and personal loans.

Living on loans is never a personal choice, but sometimes debt is unavoidable like for investing in a property or buying a car. The majority of homes and passenger cars in the country are now bought on loans and serviced through equated monthly instalments (EMIs).  However, many households now use personal loans or credit card debt to buy consumer durables, and furniture and even pay for holidays or fancy weddings.

Personal indebtedness can become a financial headache when interest rate rises and disposable income fails to catch up either due to a higher cost of living or a downturn in the job market. India is facing such a problem right now. 

There has been a sharp rise in interest rates in the last one year and living expenses are up across the board due to higher inflation. At the same, there has been a slack in the job market due to a sharp cut in hiring by tech companies and start-ups.

A big personal loan in a rising interest rate environment and a tough job market can create financial headaches for many families. The good thing is that high indebtedness like all other financial problems is easily solvable. It takes time, a bit of financial discipline, patience and finally some lifestyle sacrifices in the near to midterm. Here are five steps to get out of a high level of personal debt.

1. Calculate your Loan Servicing Ratio (LSR) 

The first step to tackling the high debt problem is to measure the size of the monster. This can be done by calculating your family Loan Servicing Ratio or LSR. This will give an idea of the debt servicing burden on your family income. First add up all your income and cash flows, including imputed savings on house rent if you are living in a house bought on loan. 

The next step is calculating the combined monthly outgo on all your loans. Now divide your monthly income or cash flow with total monthly EMI to get LSR. 

Loan servicing is not a concern if your LSR is higher than 3X. You can still manage with some adjustment to your spending if LSR is above 2X. 

However, if your LSR has fallen below 1.5X then you should think of repaying some of the loans in your portfolio.

2. Work out your net worth 

Your personal or family’s net worth -- the difference between the current value of assets and debt -- is the crucial number that tells you where you stand financially. Here assets include home, land, stocks and mutual fund units, the surrender value of life insurance policy, the current value of your car or two-wheeler, bank balance and FD and gold and silver in the possession of your family. 

Also Read: How to calculate your net worth and use it to maximise financial gains?

If your net worth is positive and growing faster than your financial liability then debt should not worry you much. But if your net worth is not growing either because your assets are not growing in value or debt is growing faster, then it’s a signal that your financial condition is worsening.

3. Check the interest rate on your loans 

The interest rate on the loans determines the servicing cost or EMIs. If the EMI is high and you find it tough to service it, see if your lender offers the option to reduce the interest on your loan. 

Most banks and NBFCs will reduce the interest on your loan for a small conversion fee. 

This option is most common for home loans but you can also reduce the EMI on your car loan through balance transfer to other banks that offer lower interest rates. Another way to reduce EMI is to extend your loan term or tenure.

4. Tackle personal loans first 

Make a list of all the loans you have on your books, from home to vehicle and personal loans such as credit card debt. If most of your loan is for funding asset purchases such as property and vehicles then you shouldn’t worry too much. A loan for an asset that can yield income is self-extinguishing if you wait out for a long period. 

If the EMIs on these loans are biting then try to calibrate your consumption spending or negotiate with banks to reduce the EMIs by increasing the loan tenure or reducing the interest rate. In the worst case, you can always sell the asset and repay the loan.

Your priority should be to tackle and reduce consumption-related loans such as credit card debt, bank overdrafts and other personal loans. These loans typically come with high interest rates and they can quietly become a big burden on your monthly cash flow. Use your savings or borrow from family members or even friends to repay these high-cost loans.

5. Borrow against your assets 

Interest and thus EMIs on loans against assets such as house and property, gold jewellery and life insurance policies are far lower than personal loans and credit card debt. Use your net worth and family assets to get low-cost loans and repay high-cost expensive loans. This way you will save on EMIs which will improve your cash flows and your LSR will rise. 

The top loans on existing home loans and any loan against property should be your first option followed by loans against gold jewellery. Another option is to make a premature withdrawal from your provident fund to repay a part of your loan. Provident fund allows you to withdraw a part of your contribution to prepay home loans.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

Also Read: Ten best hybrid funds for investment

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