Living on debt is never a great idea but sometimes it is unavoidable as in the case of buying a property or a new car. The majority of houses and personal vehicles in India are now financed through bank loans. Many people also resort to personal loans to fund big-ticket expenses such as home appliances, family holidays or home makeovers. These consumption loans are not desirable but they are fine as long as their duration is short and easily serviceable from your existing income.
Personal indebtedness can however turn into a financial headache when interest rate goes up and disposable income takes a hit either due to a rise in cost of living or a bad job market or both. India is facing such a problem right now. There has been a sharp rise in interest rates on all types of loan products in the last year and living expenses are up across the board due to a rise in prices of almost all goods and services including home rentals.
Besides, the condition in the job market has worsened due to big layoffs by tech companies and start-ups and a huge cut in fresh hiring by India’s IT majors such as Tata Consultancy Services and Infosys.
A big personal loan with a rising interest rate and a tough job market can be a troubling combination for many families.
Anecdotal evidence suggests that many families are now facing the dilemma where they have to decide whether to pay EMIs on their loans or cut down on essential living expenses. If you are one of them, then don’t despair. It’s tough but not impossible to tackle high debt. You just have to follow a process and exercise some financial discipline.
Here are five ways to come out of high personal debt:
1. Know your debt problem. Start by making a list of all the debt you owe to banks and other entities including credit card debt and various dues and bills unpaid to your building society or the utility provider. Now arrange all the debt in the order of priority and interest rate. For example, you cannot afford to miss monthly payments on your home or car loans as you may lose your house or your car. But you can always defer the payment on unsecured personal loans or monthly dues to your society.
Similarly, high-interest loans such as personal and credit card debt should be tackled first while loans with low interest rates can be managed later.
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2. Work out a repayment plan. Now that you know the nature and the size of your debt problem, it’s time to make a loan repayment plan. Sit with your spouse and other family members and take a hard look at your income and expenses and start making extra savings or start prepaying some of your debt.
If it’s not possible to prepay the loan in one shot, then make a part payment every month, every quarter or even a year.
Repaying high-interest loans such as credit card debt will help you save the most money in the long run. However, some personal finance experts suggest that you should tackle the smallest debt first regardless of the interest on them.
3. Tackle high-interest loans first. Unsecured personal loans such as credit card debt and loans for big-ticket consumption carry very high-interest rates that translate into higher EMIs. They should be paid off first.
You can start by repaying the smallest of these high-interest loans by making additional payments over the minimum required payment every month.
For example, interest on credit card loans can be as high as 40 percent per annum and any delinquency here would soon snowball into a big debt even if the initial amount of the loan is relatively small.
Repaying high-interest loans will also create financial headroom for you to tackle big-ticket loans such as home or car loans.
4. Reduce the interest rate on your loan. The interest rate on homes, property and loans against property (LAP) are floating and linked to external benchmarks via a spread mechanism. If you feel that the EMI on your home loan or LAP is too high or the repayment period has gone up sharply then check the possibility of reducing the interest on your loan either through balance transfer or loan conversion.
Most banks and home finance companies will reduce the interest on your loan by changing the spread for a small conversion fee.
This option is most common for home loans and LAP but you can also reduce the EMI on your car loan through balance transfer to other banks that offer lower interest rates. You can opt to reduce your monthly EMI or reduce your repayment period. The latter is better in the longer term.
5. Leverage your family assets to reduce your debt. While it's always advisable to use your current income and cash flow to reduce your debt, this may not work for everyone and in all circumstances. In this situation, a loan against assets such as a house, land, commercial property, gold jewellery, life insurance policy or even stocks and mutual funds units is a good way to reduce your debt burden.
Interest on loans against assets is far lower than those on unsecured personal loans. Here the top-up loans against current home loans should be the first option followed by loans against LIC policies followed by gold loans.
So go for a low-cost loan against assets and use the proceeds to repay your high-cost debt. It will translate into significant savings in EMIs which will enable you to repay even these assets-backed loans in future.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).