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The debt sentence

Taking a loan to repay another is rarely a good idea—and is worse during recession. But there are ways out of the debt trap if you enforce self-discipline, says Priya Kapoor.

What were you doing at this time last year? It’s likely that you were fending off calls from an over-enthusiastic tele-marketer trying to ‘give’ you a free credit card or a low-cost loan. Many of us would have cut short the sales pitch, but some of us would have listened. After all, a free credit card is good news, right? It’s a status symbol, but more importantly, it allows you to spend even more. You might have told yourself, what’s the point of earning so much if you can’t enjoy it? “Consumer behaviour has changed a lot in the past few years. Today, an individual wants everything within the available salary, and he gets it easily on credit,” says V.N. Kulkarni, head, Abhay Debt Counselling Centre (ADCC), Mumbai.

Buying on debt is not a bad idea if you can repay it early and not spend a fortune on interest. It was easy till about a year ago, but the markets crashed, then came recession, liquidity cruch, job losses, salary cuts, and uncertainty on the earning front. Debt was no longer something you could afford to have simply because you could not afford to repay it. No matter what your financial plan, it’s unlikely that you planned for such a fall. Banks, which were once willing to be flexible, are now demanding repayment on time. In fact, there’s a joke doing the rounds these days: Do you think nobody cares if you’re alive? Try missing a couple of car payments. Jokes aside, how do you repay the existing debt? Many people instinctively opt for a loan, not realising that they are entering a classic debt trap. Once in, it’s very difficult, but not impossible, to get out. We look at the most common reasons why people fall into such a trap and consider steps they can take to extricate themselves.

Credit Cards: Plastic Power
There are nearly 27 million credit card users in the country and their average monthly card spend is Rs 2,200-2,400. But over 40% of the users are content to pay the bare minimum and roll over their credit. The immediate impact is that this leads to huge amounts due to the card company (interest is charged on the entire amount). In the long term, card companies report larger non-performing assets (NPAs), which affect their profitability and could lead to increased interest rates or more stringent penalties. Last year, the NPAs in the banks’ credit card portfolio were 5-8% and have gone up to 20% in the current fiscal.

Anita and Sunil Choudhary know about the high fees, interest rates and penalties. They’ve been there, paid that—and are still paying. They started off with one credit card and only paid the minimum due every month. Their monthly statement got bigger and bigger and when it seemed too unwieldy to handle, the Choudharys simply applied for a second card. “We paid off the minimum amount on our first bill thinking that we would soon settle the entire amount, but we got hooked to the habit and are now under a severe financial burden,” says Sunil. Today, they have five credit cards and one personal loan with consolidated outstanding dues of Rs 5 lakh.

The Choudharys are not alone, of course. For people who believe that rolling over credit makes good financial sense, Veer Sardesai, a Pune-based financial planner, has some advice. “One should try to settle the entire bill at one go. The facility of paying the minimum amount due should be used only when there is a genuine financial crunch. Settling the outstanding amount on one credit card with another credit card is another mistake that compounds the problem. It’s not a good move as both are high-cost debts,” he says.

• Swap high-cost debt with a low-cost one. Take a loan, even if it's a personal one with a 12-22% interest, to repay the high-cost debt. Repaying the single loan might be easier on your pocket than a series of high-cost ones.
• If the EMI of the personal loan is too high to be serviced through your salary, approach the banks for restructuring. Most banks will increase the loan tenure while keeping the interest rate intact.

Personal Loan: High Cost
A personal loan might be the best way of servicing a large credit card debt, but ideally, that’s all you should use it for. Today, despite tight monetary conditions, banks offer loans for just about anything, ranging from higher studies to home furnishing. So taking a personal loan to fund your daughter’s MBA in the US means that you’re taking on an unnecessary high-cost debt. Education loans come with an interest rate of around 12.5%, while the interest on personal loans can go up to 22%. The good news is that more people seem to be realising the value of education loans. The value of these loans (from PSU banks alone) went up to Rs 1,242.27 crore in 2007-8 compared with Rs 559.98 crore in 2005-6.

However, this is obviously not enough. The majority of people are like Surender Kumar, who took a personal loan to finance his son’s higher studies. Kumar did not expect the EMIs to gobble up his budget; his monthly salary of Rs 25,000 was just about enough to take care of the household expenses, leaving a little amount to save. With a high-cost loan to repay, he found it increasingly difficult to make both ends meet. He became a defaulter and the bank had to send recovery agents to retrieve the money. A desperate Kumar then used his credit card to settle a portion of the loan. He still has to repay a part of the education loan, and now has to pay on the credit card as well. Why did Kumar opt for a personal loan? “I needed the amount instantly to foot the admission fee. I had no other option,” he says. The fact is that he knew of no other option. Had he taken an education loan, the interest rate would have been halved and he might have been able to pay.

“There is very little awareness among individuals about the different forms of credit available in the market. People think that personal loan is the solution to all their financial woes and don’t bother to look for cheaper options,” says Kulkarni of ADCC.

• Settle your personal loan first as the interest rate is among the highest. Ideally, take a loan against your provident fund to settle these dues. The interest rate on this is 9-10% and your employer can deduct the amount from your salary on a monthly basis.
• If you have taken a personal loan to fund school or college fees, you can refinance it with an education loan (if the bank offers both). All you have to do is show proof that you have spent the personal loan amount on fees. The bank will sanction an education loan, which you can use to pay the personal loan. You can then repay the low-cost education loan with greater ease.

Loan for Emergencies: Plan Ahead
Financial planners usually insist that their clients put away a specified amount—usually at least three months’ expenses—in an emergency fund. The rationale is that health insurance takes care only of hospital bills; living expenses are not taken into account. As Rahul Aggarwal, CEO, Optima Insurance Brokers, says, “Only 2.5% of the Indian population is covered by health insurance. Most think that they will never have to face any medical problem, and if they do, they can borrow easily. A medical problem or accident can cripple you financially, so it’s always advisable to plan for such exigencies.” With no health insurance and no emergency fund, people have no option but to take a loan to manage the exigency.

Of course, we all wish we had medical insurance usually when it’s too late. Manoj Verma too regrets not having planned better. The 65-year-old businessman had a heart attack last year and was stuck with medical bills of Rs 9 lakh. The only way Verma could pay the bills was by taking a personal loan. But soon after, he found that his health would not permit him to continue with his business, so he had to shut shop. With a large loan and no earnings to speak of, Verma barely manges to pay Rs 2,000 a month to service the loan.

• When you have practically no money left to pay back, you may have no option but to ask the bank if it will agree to write off the loan.

Bonus/Increment: Don’t Bank on it
For some years now, salaries have been going through the roof. Bonuses and incentives were more than enough to pay for luxuries. People took on far more debt than they could have afforded, assuming that future increments would take care of the repayments. Unfortunately, bonuses and hikes have been coming down; data from Hewitt India shows that the average salary hike went down marginally to 14.8% in 2008 from 15.1% the previous year, but could see a steeper fall in 2009, when it is estimated to be 13.9%.

Nishant Gupta is among the thousands of professionals caught in a trap of his own making. But unlike several of his colleagues, who found their repayment capacity adversely affected because of a lower bonus, Gupta found himself with no income and a large debt. When he was earning Rs 25 lakh a year, Gupta took a personal loan of Rs 3 lakh to make the down payment for a Rs 10 lakh car. Soon after, he had a disagreement with his employers and quit. Gupta is now stuck with a personal loan of Rs 3 lakh, a car loan of Rs 7 lakh, monthly expenses (including house rent) of Rs 1 lakh— and no earning.

“Depending on future unrealised income for repayment of loans can land one in great financial trouble. While borrowing, most think that they will continue to earn at least the same amount and don’t make provisions for the future,” says Jaideep Lunial, a certified financial planner.

• In a case like Gupta's, experts advocate liquidating the existing securities, particularly assets like gold.
• Don't wait for a job that offers similar pay; even a part-time job can help repay loans.
• Ask if the bank will restructure the loan to give you softer EMIs.

Borrowing for Stocks: Poor Bet
Till a few years ago, loans were taken to pay for unaffordable goods and services. Then, thanks to the prolonged bull run, people began to play the stock market. They realised there was money to be made in equities, and regardless of whether they had the resources or not, they dabbled in shares. An increasing number of investors took personal loans to buy shares. When banks began lending against shares, the people who wanted to get rich really quickly started pledging their scrips with the banks for a higher exposure in the market. Banks lend around 60% of the value of scrips and charge 14-17% interest.

Vijay Sharma, a 40-year-old Delhi government employee who has a monthly salary of Rs 18,000, realises the mistakes he has made. Some months ago, Sharma took a personal loan of Rs 25 lakh to buy stocks, assuming he would easily make double this amount in a few months and repay the loan. Today, all his shares are in the red, and he doesn’t have enough to repay the huge loan.

“It is not advisable to trade in market with borrowed money. Moreover, equities are for the long term. Things can be fine when the market is up, but it can cost you heavily if it goes down,” says Sardesai.

• Find out if the bank will restructure your loan or allow you to skip a few payments.
• Government employees like Sharma can use the arrears of the 10th Pay Commission to pay part of the loan.

Loan for Lifestyle: Status Quo
Neighbours can be responsible for a lot of problems— including debt. It’s invariably the neighbour who has a fancy car, which forces you to buy one. The neighbour went to Paris for a holiday, so you must at least go to Amsterdam. And so it goes. It happens on several different scales, but the end result is invariably the same— you spend more than you can afford for something you don’t really need.

Ask Mayank Shetty, 30. He earns Rs 15 lakh a year, and has never planned his finances. He spends on big brands and expensive products, and has not bothered with asset creation. Today, Shetty has eight credit cards and a personal loan, and owes Rs 15 lakh. He had hoped that his bonus would take care of much of this, but his company announced a pay cut of 13% and no increment.

Dheeraj Gupta who earns Rs 40,000 a month doesn’t spend as much as Shetty on expensive gadgets. Instead, he assumed that his bonus would be sufficient to pay his wedding expenses and so wiped out his savings and took loans of Rs 25 lakh to pay for his wedding and gifts. Unfortunately, soon after the wedding, his wife fell ill, and most of Gupta’s salary and bonus went into meeting the hospital bills. He still has the Rs 25 lakh loan to pay.

• If you have huge credit card dues, experts suggest that you convert them to EMIs. This enforces discipline in the repayment dues. Also, credit card debt, when converted to an EMI, bears a lower cost of interest of 22-25%.

Published on: Dec 25, 2008, 7:08 PM IST
Posted by: AtMigration, Dec 25, 2008, 7:08 PM IST