Funding short-term goals – why you should stay away from debt!
Gone are the days when availing credit from banks and financial institution entailed a long-drawn process and was a daunting experience for the common man. Sea changes have ushered in the financial services sector and one of those changes has made lives easier for us – the easy availability of credit. Be it emergencies or indulgences, credit cards can be a great financial tool when you may not have funds at your disposal.
It is this flexibility that has made it very common for people to rely on credit for fulfilling short-term goals. However, credit cards and easily available loans can induce a sense of complacency which has the potential to suck you into a vicious debt cycle, especially if you are someone who has struggled to keep expenses in check.
The bigger picture
That the easy availability of loans can be a trigger for debt trap problems can be ascertained by the fact the proportion of loans disbursed to those with income below ₹3 lakh has grown in the last three years, according to a CreditScape report published recently by the CRIF High Mark, a leading credit information bureau. Between April 2020 and Dec 2020, 67 percent of the personal loans has been given to this segment of borrowers, as opposed to 69 percent in 2019-20 and 63 percent in 2018-19, the report said.
The sense of complacency that grips many credit card users can lead to a misinformed idea about how they can meet their short-term goals by relying on debt. Arjun Chhabra, a chartered accountant based in Ranchi describes, “The common perception is that since you can keep paying your EMIs or credit card bills at a later date, it is fine to go on that vacation or indulge yourself by swiping the plastic or by taking a personal loan. But people often tend to underestimate how interest rates on loans and credit card dues can have a damaging effect on your finances in the long run. You will essentially be spending more money on meeting those goals because of interest payments than you would have had you used your savings or investments instead.”
Chhabra narrates further, “I learnt the benefits of goal-based investing only after having made the mistake of using credit for my short-term goal. The trickle-down effect of high interest rates derailed my financial plans for my long-term goals to an extent and while the damage wasn’t significant, it was enough to make me realise that I should have made short-term investment plans that had the advantage of liquidity – my investment could have possibly appreciated by an amount comparable to what I paid as interest on the loans I took.”
Good debt vs bad debt
Home Credit India, a local arm of the international consumer finance provider with operations spanning over Europe and Asia conducted a survey in Nov 2020 to gauge loans and borrowing preferences. 27 per cent of respondents cited repayment of their monthly installments from the earlier loan as the second-biggest reason behind borrowing.
Deepak Chhabria, CEO of Axiom Financial Services explains that when spending is fuelled by excess credit, it can result in a debt trap which in turn can be the genesis of a vicious debt cycle. “People often resort to taking personal loans or rollover credit card payment to tide over short-term cash flow issues. This can be avoided with little bit of planning. Debt for creating assets is different from debt for consumption. For example, a housing loan for purchasing a property is infinitely better than taking a personal loan for a holiday or for buying the latest gadget. Deferment or delayed gratification is a better option. Also, a simple SIP in a liquid or suitable debt mutual fund can accumulate a reasonable sum for short-term goals.”
Chhabria opines that a lack of foresight often pushes people to tap into debt for meeting their goals. “Investors should correctly ascertain their ability to service debt. Often, EMI payments are disproportionate to the income or the decision is based on the premise that one’s income will continue to rise in the same manner, thus creating the impression that the mortgage is serviceable. Instead, investors should use SIP and accumulate the corpus and make bigger down payments and manage EMIs so that cash flows can be managed without the need for availing personal loans or defaulting on EMIs which can bring down their credit scores.”
Parvati Iyer chief investment officer at Femwealth.com, an online investment management portal, asserts that small contributions to debt funds can be a more prudent way to fund short term goals. She says, “Short term goals could be anything for which you need money within 3 months to a few years down the line. These short term goals may include an emergency corpus, buying a car in a year, or your dream vacation. The duration of the goal narrows down the choice of debt mutual funds to be employed. One can choose from liquid, ultra short term and short term debt funds. The three types of funds are reasonably safe and if held for 3 years or longer, then they are very tax- efficient. They are taxed as a long-term capital asset and adjusted for inflation through indexation.”
With debt funds you can also reap the advantage of reducing your existing EMI burden, Iyer feels. “For example, down payment for a house in 2-3 yrs is a good near term goal. Regular contributions over the years to short term funds can help you accumulate a sizable down payment thus reducing your EMIs and loan needed. Most short term debt funds have zero to low exit load for withdrawal. It is customary to match the goal duration with the type of debt fund in which case exit load rarely applies.”
• Should it be absolutely necessary for you to tap into your credit reservoir for meeting short term goals, do not forget to estimate the cost of interest payments and how that would affect your finances.
• A good way to know when you are going overboard with your credit card expenses would be to check your credit utilization ratio. It is a percentage of a borrower’s total available credit that is currently being utilized and also has a bearing on your credit score. Experts say that you should aim to keep your credit utilization ratio at less than 30 percent.
• While delayed gratification isn’t the strongest trait for many of us, learning to resist instant gratification can help you steer clear of debt traps. This can help you differentiate between your ‘needs’ and ‘wants’ and also stay on track with your savings and investments plans because you wont be diverting your money for purchases that you can do without but seem too tempting.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.