A quick guide to freedom from debt

Loans | admin | January 11, 2011 at 9:32 am

The answer was a clear no. Kiran Shetty, a 36-year-old IT professional was aghast. His bank had just rejected his application for an auto loan. He was curtly told that since he already had huge outstanding debt against his name, the bank could no longer sanction him more loans.

Kiran did a quick reality check and found to his horror that he was spending 68% of his income in repaying debts. He had taken a personal loan two years ago and a home loan taken last year. As he had opted for a floating rate of interest, the equated monthly instalment kept on rising with every revision in interest rates. To top it all, he also had an outstanding on his credit card.

“When I had taken the loan, the interest rates were less than 8%, now I pay nearly 12.5% on my principal amount. Also, though I have less than one lakh rupees outstanding to pay on my personal loan, I still have to pay around Rs 8,666 for the next 10 months,” he says.

Shetty is baffled by the ballooning debt. “I used to make prompt payments whenever I used to get the credit card bills. I have never defaulted on my payments, I really have no clue how my outstanding payment could have gone up so much,” he says while admitting that he used his credit card for even mundane buys like food items and groceries.

As a part of his New Year’s resolution, Shetty has decided to pay off most of his liabilities and become debt-free. “I don’t mind liquidating my investment in shares for doing so. Also, my fixed deposits worth Rs 90,000 are also maturing in the coming months. But it’s just that I don’t know where to start from,” he says.

Shetty’s case is not a standalone one. There are many who like to stretch their financial limits, says Jayant Vidwans, president of Society of Financial Planners. “Most people realise their payments have burgeoned when their bank accounts go dry suddenly.” Making a list of Shetty’s total income and expenditure, Vidwans found that nearly 68% of his Rs 40,700 salary goes into paying off his loan instalments while he just manages to get around Rs 9,300, or 32%, of his Rs 60,000 salary for his other expenses. Ideally, loan payments should not exceed more than 33% or one-third of one’s monthly income, says Vidwans. “However, that does not happen in most of the cases. We tend to over-step our limits,” he says.

Vidwans and a group of other experts had a look at Shetty’s monthly income and expenditure statement and decided to help him lower his debt burden.

Shetty’s Credit Card Payments: Rs 4,000 p.m (6.67 %)

Shetty has outstanding payments of around Rs 80,000 on two of his credit cards for which he makes a minimum payment of Rs 2,000 each whenever the card companies send him the bill. Vidwans informed that despite the fact that credit card payments attract the highest rate of interest — around 3.1% to 3.6% per month — most individuals still prefer to use the credit card to make payments.

A credit card company gives 50 days of free-credit period to users. If the payment is done during that time, the interest component is not charged. However, if the consumer just makes a minimum payment at that time, then during the next purchase, the free credit period ceases to exist and the interest component is added to the new purchase as well.

“One of the mistakes that most cardholders make is that they just make the minimum payment when they receive the credit card payment bill rather than making a full payment and enjoying the benefits of the free-credit period. The balance which is carried forward attracts a monthly interest of 3%,” says Jayant Pai, vice-president, Parag Parikh Financial Advisory Services.

Pai says that once the borrower decides to carry forward the balance amount, the benefit of free credit ceases to exist on all the fresh payments he makes through the credit card. For all new purchases, the card company levies a rate of 3-3 .5% from the first day onwards. Almost all credit cards allow you to pay 5-10 % of the amount due as minimum payment and make the balance payment later. This is called the rollover facility. But this facility comes at a steep interest cost that can be as high as 45-50 % per annum in certain cases.

For example, if a consumer makes a purchase worth of Rs 100, then for the next 50 days, he has the option to make interest-free payment. However, if he chooses just to make the minimum payment say Rs 5, then Rs 95 is carried for the next cycle for which interest is charged. Now, if he makes an additional purchase worth of Rs 100 again, the bank immediately starts charging interest on it as the free credit facility ceases to exist on the second purchase. This is because there is already an outstanding of Rs 95 which has been carried forward.

Ramesh Bhojwani, a financial consultant, feels that Shetty should try and repay his credit card payments first with the help of the money realised though the maturity of his fixed deposit. “People like Shetty should resort to making payments through their debit card rather than through credit cards,” he said.

Parikh Financial’s Pai says that Shetty can target cleaning off one card at a time, in case he wants to retain some liquidity. “He can make the minimum payment for sometime on one card which attracts a lower rate of interest.”

Personal Loan: Rs 8,666 p.m. (14.43%)

Once Shetty takes care of his credit card loans, the personal loan should be his target next, as it is the second-most costly loan with an interest component of 18% p.a, says Bhojwani. Since Shetty has an additional liquidity of 14-15 %, it can be used to pay the balance sum on his personal loan which is around a lakh of rupees, he says. “Private banks generally don’t have the facility of part paying personal loans. They also levy foreclosure charges which range from 2-4 % of the balance amount.”

Bhojwani also recommends liquidation of some of Shetty’s stocks which can help bridge the gap. “His stocks have already appreciated. At this stage, he can expect to get a return of 10-15 % and not 20-25 % which he may have received from the markets in the past few months.

So, he can choose to sell off some of his shares and clear off his balance payment on his personalloans,” he says. Since most of the public sector banks don’t levy a prepayment charge and the rate of interest is also low compared to private sector banks, borrowers can look at it as an option for auto and personal loans.

Housing Loans: Rs 28,000 p.m. (46 .67 %)

At this stage, nearly 21% of Shetty’s loan payments are taken care of. According to Pai, Shetty would now be in a much more comfortable position to tackle his home loan payments. He says that the rate of interest for public sector banks (PSBs) is generally lower as compared to private sector banks.

“He can make use of the additional liquidity to increase his payments, thus freedom from loan reducing the payment tenure,” he says. Many consumers these days are shifting their loans from private sector mortgage lenders to public sector banks to take advantage of the wide difference between the interest rates, which is as high as 250 to 300 basis points in some cases.

“However, before doing that borrowers need to look at various charges the new bank would levy like the processing and the administrative fees plus the prepayment charges in case the existing bank is charging,” says Bhojwani.

People like Shetty should avoid the temptation of financing impulsive buys with credit cards. In case of a genuine need, search for the most economical borrowing and repayment options before applying for a loan.

Source: Economic Times