TomorrowMakers ™

Financial Planning

How to be on the right side of debt

17 February 2017
Living in debt has become a way of life. It's time we changed that!
 

By Sunil Dhawan

Living one’s life on debt or on EMI’s is fast becoming a way of life. The use of credit cards and personal loans to meet day-to-day expenses is gaining strength. According to the Reserve Bank of India’s recent data, personal loans increased 16.6 per cent in May last year compared with an increase of 14.8 per cent in the same period a year ago. Even credit card outstanding grew to 23 per cent in May 2015 against 14.2 per cent in the corresponding period a year ago.

Debt and financial planning: Debt is what we owe (to a person or an institution) and comes at a cost in the form of interest payments on loans. Adhil Shetty, CEO and Co-founder, Bankbazaar.com, says, “Contrary to popular perception, financial planning is not only about savings. It is about organizing your finances – both investments and loans – so that you have a sustainable plan to meet your future expenses.” Therefore, debt has an important role to play in the financial planning of an individual. If an investor manages to generate a return of, say, 12 percent per annum from one’s investment portfolio but pays a similar percentage as interest towards a loan, the net effect is not helping him to create wealth. Therefore, the first thing investors need to do is to get rid of any debt, which eventually eats into one’s returns. Loans such as personal loans, credit card, home loans, car loans etc are the forms of debt.

Constructive and non-constructive debt: All the debts that one acquires need not necessarily be bad debts. Spending on credit card or through a personal loan is by nature non-constructive debt. It is primarily used to purchase consumer goods or to meet lifestyle expenses which typically do not appreciate in value. The interest paid to service such a loan is entirely a cash outflow with no enhancement in the value of the underlying asset/good/service.

Housing loan, on the other hand, is a constructive debt. Over time, the value of a property is expected to increase. Buying a home by financing it through a housing loan is therefore acceptable.

Related: Investor's guide to managing money [eBook] 

Managing EMI’s: Living a life on EMI’s to fund car purchases, home buying, eating out and for making other lifestyle expenses needs control and proper management. As a thumb rule, one’s monthly outgo towards all loans put together should not be more than 50 per cent of one’s monthly take-home pay.

Perils of debt: Credit cards and personal loans are unsecured loans and therefore carry high interest rates than other kind of debts. The interest rate on personal loan is currently in the range of 13-18 percent or even higher in some cases. The interest rate one pays on the outstanding balance of credit cards (after rolling-over) is in the range of 36-48 percent per annum. Such unsecured loans, especially credit card spending, if not managed well can be financially damaging. Shetty informs, “While unsecured loans are not always desirable due to their high interest outflow, they often come in handy in times of emergencies. While personal loans are the first things that come to mind when we speak of unsecured loans, credit cards too work well as unsecured loans. For instance, if you charge an item in May, it typically will get reflected in the bill you get in June and you may have until July to pay it back. That's essentially an interest-free loan if you pay the June balance promptly.”

Related: 4 time tested tips to help you get out of debt in 2017

Remember, a proper usage of debt plays an important role in shaping one’s credit history for any future requirement of loan.

Conclusion: Debt should be avoided as much as possible. However, if you need it sometimes for any unavoidable reason, then try to use it judiciously. Whatever be the case, over-leveraging and untimely payments should always be avoided to lead a debt-free life.

Source: Economic Times

 
 
 

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