How to manage your finances in the face of a debt overload
For a chunk of the population, the knowledge that they can tap into a reservoir of funds in the forms of loans and credit cards, whenever they require is a comforting thought. Be it buying one’s dream home or the newest gadget or even booking tickets for that ‘Gram’ worthy vacation, an increasing number of Indians have come to depend on credit for ticking off items from their bucket lists as well as emergencies. This is evident in the fact that India’s household debt surged 1.8 times from Rs 3.7 lakh crore to Rs 6.74 lakh crore between 2016-17 and 2017-18 growing at an annualised rate of over 13% in the past 5 years.
The rising culture of raking in debts for has also made the problem of debt overload increasingly common. Efficient debt management continues to remain an elusive concept among sections of the population and many find themselves dealing with the challenge of debt overload. Two out of three borrowers in the country are unaware of their CIBIL score and 76 per cent of the borrowers did not know the interest amount on their loans, according to a recent survey by Home Credit India. A debt overload can become a malignant issue for your finances and needs to be dealt with carefully.
The enticement of readily-available credit
The easy availability of credit has made debt management a slippery slope. The misplaced sense of complacency that you can always rely on debt for that one indulgence and that you can pay it off later is the easiest way to get tracked into a debt cycle. Before you know, the garnishing with high interest rates makes your debt servings extra large. According to documents filed by SBI Cards and Payments Services, the credit card division of the State Bank of India for its initial public offering in 2019, credit card dues are expected to grow at a compound annual growth rate (CAGR) of 23 per cent to reach Rs 3.3 trillion by FY 24 and credit card spends is expected to grow to Rs 15 trillion by FY24 from Rs 6 trillion in FY19.
For Aashna Bhatia, things on the financial front were going smooth until she realized that her credit card debt had swollen to unmanageable levels. Bhatia, a freelance graphic designer had taken a break to focus on the personal front and when her self-imposed sabbatical came to an end after a few months, the credit card bills came as a rude shock. “I decided to take a break for my nuptials and amidst the wedding madness, reviewing my finances took a backseat. I missed my credit card bill payment and the mounting interest that along with my existing EMIs landed me in a tough spot. It taught me the lesson that debt can be a silent poison and prudence is indispensible when utilizing debts.”
Differentiating between good debts and bad debts
A debt overload problems has many tentacles all of which can have a long lasting impact on your finances. Be it dwindling credit scores, depleting savings and losses incurred on investments for paying debts – dealing with a debt burden needs a careful multi-pronged strategy.
Arjun Chhabra, a chartered accountant based in Ranchi opines, “Most people have the misconception that randomly paying off debts should do the trick. But, you need to know what constitutes good debt and bad debts. When the interest rate is low and fixed, and the loan has been used to buy something that grows in value, it is good debt but loans with high or variable interest rates that are used to buy things that lose value fall in the territory of bad debts.”
Chhabra explains that repayment strategies should be based on the kind of debts you have incurred. “You can either choose the debt snowball or the debt avalanche. The latter is better suited if you have big ticket high interest loans so that you can save money on interest payments. It will also spare you from the trouble of having to dip into your savings or investments for paying them off because high interest debts left untended to for long can become unmanageable.”
Strategizing repayment with mutual fund investments
Elaborating on how good debts and bad debts need differing strategies, Parvati Iyer, chief investment officer at Femwealth, an online wealth management platform says, “The overhang of debt often takes more money away from you than you make from investments. An example is credit card debt. The interest repayments can often exceed your yearly investment returns.”
Iyer emphasizes that bad debts need to be tackled first: “Bad debts including and especially credit card debt needs to be paid off first without exception. Typically one attacks bad debt with the highest interest rate first. If possible, debt consolidation or refinancing that reduces the overall outgo or interest rate is a help. For good debts, you can use different allocation models and have a portfolio of equity and debt mutual funds. Even if the debt overload dwarfs everything, invest a little in equity mutual funds to create a healthy investment practice. And instead of taking on debt for large expenditures including cars, vacations, jewellery etc, one should plan ahead for this goal. It is easy to allocate across equity and debt mutual funds to meet such goals.”
Srikanth Bhagavat, managing director at Hexagon Wealth also strictly advises against draining one’s savings for repaying debts and advocate SIPs. He says, “A high level of debt requires that the person change his or her lifestyle drastically to control expenses. The savings should be used to pay back and reduce debt. In many cases, it may not be practical to use these savings to repay on a monthly basis due to restrictive clauses in the loan pre-repayment terms. Mutual funds can come to the rescue here – the savings can be invested in money market funds or liquid funds and accumulated there. At the end of the year the accumulated savings can be used to make a pre-payment and reduce outstanding debt. In this manner the savings are put to good use and returns generated instead of being left idle.”
•If you are struggling to repay your EMIs and credit card bills, it is imperative to revise your budget and channelize all unnecessary expenses towards debt repayment.
•Additional sources of income such as a side hustle can help alleviate your debt situation.
•You may consider seeking help from a debt relief company if you are struggling to keep yourself afloat.
•A high level of debt requires that the person change his or her lifestyle drastically to control expenses. Mutual funds can come to the rescue here – the savings can be invested in money market funds or liquid funds and accumulated there. At the end of the year the accumulated savings can be used to make a pre-payment and reduce outstanding debt.
•For good debts, you can use different allocation models and have a portfolio of equity and debt mutual funds. Even if the debt overload dwarfs everything, invest a little in equity mutual funds to create a healthy investment practice.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.