Debts are not always a bad thing. In fact they have the potential to enhance our financial portfolio in the form of home loan, car loan, personal loan etc., and help us build wealth through investment in appreciating assets. For example, a home loan increases your purchasing power to buy a house worth an amount beyond your means. You don’t want to wait till you create a fund, as the price of the house would only increase in time and surpass your fund size.
So, debts can be looked upon as instruments that improve your financial health. However, an over dosage can be overtly harmful for your finances. You have to be watchful of the repayment load you take upon. Ideally your EMIs should not eat into more than 35% of your income. If it consumes anything over 45% to 50% of your income, you are likely to fall into a debt trap, wherein you take one loan above another to clear off your existing debts. The path to recovery is a hard way up. So it’s best you watch out for these early signs and take preventive measures.
Unable to repay your credit card bill on time
The use of digital payment options, especially credit cards, have gone up with time. After all it gives you the convenience of buying first and paying later. And rewards and cash back on purchases. You also get an interest-free period to accumulate the repayment amount. However, if you miss making repayment before the due date, the interest on the outstanding amount accrues at an annualized rate of 35-40%, or 3-4% a month. Most credit card companies allow you to make a minimum payment of around 5% but it only saves you from late penalties and not interest charges. If you repeatedly miss clearing off your bill entirely, your bill will grow out of proportion because of the high-interest charges.
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For example, say you have an outstanding amount of Rs. 100,000. Now, if you make the minimum payment for a straight 15 months, you will have paid Rs. 69,016.20 on the balance. Calculating the APR charges at 4% per month, you have repaid only Rs. 16,564, and your balance still stands at Rs. 83,436. In fact at the end of five years, your outstanding credit card balance would be Rs. 48,463 even though you would have already repaid a whopping Rs. 214,734.53 as minimum payments over 60 months. In order to keep the bill in control, it is recommended you keep the expenditure within 20% of the credit limit on a card.
Falling credit score
Your credit report can reveal a lot about your financial health. Your credit score is an indicator of your credit worthiness, which is determined based on your credit history. If your score is above 750, it shows that you have been regular with your loan repayments. On the other if it is any lower, it is a sign of either irregularity in EMI payment, delayed repayment of loan or credit card or too many new loan or credit card requests etc. Check your credit report from time to time to understand where you stand and make necessary amends. You can check your score online without having to go to any bank or financial institution.
Banks refuse to sanction loan
If your loan application faces rejection at a bank, it’s probably a sign that you are already burdened with financial liabilities. Banks look at your income and credit score in order to check your credit worthiness before lending you money. And, if you already have too many loans in your name and you haven’t been making timely repayment for them, you are likely to have exhausted your borrowing potential, knocking down your credit score. However, it’s not the end of the world. You can pull yourself through this situation by clearing off some of the existing debts before applying for a new loan.
Taking a loan to service another loan
If you are unable to pay for EMIs from your pocket, and are forced to service another loan to pay off an existing loan, it’s a sign your finances are going downhill. You are getting into debt to take care of financial liabilities. This could soon force you into a debt spiral, as it will only increase your list of liabilities. You can prevent this from happening if you have a repayment plan in place before you opt for a loan. Also make sure the repayment load is not more than 35% of your income.
Taking loan for luxuries
Taking a loan to build appreciating assets works well for your finances. Home loan and education loan are some such loans. On the other hand, a loan taken to fund vacation or throw a party is unnecessary and best avoided. Consumption of this sort is best funded within the limits of your disposable income. You can’t take a loan for everything in your wish list. So always run a value assessment and weigh the cost of the loan against what you are gaining from it.
(The Tamil version of the above article has been published in Naanayam Vikatan magazine dt 29/7/18)