How to manage your loans effectively?
Loan management - a case study
For Swapna, 2016 December was the best month in her life. That was the first time Rajesh had taken her and children for a holiday trip to Manali. He had also bought her a silk saree and a gold necklace to wear for her cousin’s marriage during the same month. Till then whenever Swapna had mentioned about going for a vacation or buying expensive clothes, Rajesh used to advise her not to spend too much, as they have to repay their car loan and house loan. What changed Rajesh’s mind was the expectation of getting a promotion and a salary hike. While 2016 December was a memorable month for Swapna, Rajesh gets shivers now when he thinks about that month.
Expecting the salary hike, Rajesh had taken a personal loan for Rs.2 lacks. The EMI is about Rs.7230 for 36 months. He also had Rs.50,000 in his bank account. He had a credit card with a limit of Rs.75000. He used to make the full card re-payments every month. By the end of December 2014, his bank account balance was just Rs.4500, his credit card total dues were at Rs.74000 and the entire personal loan was spent.
In January he had to pay school fees of Rs.40,000 for the 2 kids. His salary was Rs.70,000. Out of that Rs.40,000 went for Home Loan and car EMI. Household expenses were Rs.20000 including the school fees which was paid on quarterly basis. He had a gold loan for which he was not making any repayments. The promotion he expected did not happen soon. He got it only after 6 months in June. By that time he had borrowed from all of his friends to cover the shortage every month.
Now, he is in a debt trap. From June onwards he is trying to repay the borrowings from friends. He is worried that he is not having any savings and has no bank balance to meet any adverse situation like falling sick.
Most of us are like Rajesh and Swapna. We want immediate gratification of our desires. And when we have to take a loan, we want to repay it as fast as possible to get out of the obligation. We are more worried about the total interest we pay and we seldom care about our cash flows.
The current situation situation of Rajesh’s family is like this. Their total take home salary is about Rs.82,000 per month. House hold expenses are about Rs.22,000. Entire balance goes towards loan payments. The total loan outstanding is about Rs. 25.03 lacks. The home loan was for Rs.25 lacks and for a period of 10 years. Now the home loan outstanding is Rs.17.96 lacks and 72 EMIs have to be paid. The current interest rate is 10.5%p.a. The house value is about Rs.40 lacks. They should take a top up loan for Rs.7.07 lacks and increase the repayment term to 120 months. Use the top up loan to repay the car loan, personal loan, gold loan and borrowing from friends. After that they will have a single loan with EMI of Rs.33,774. They will have surplus of about 26 thousand rupees per month which they can save towards their goals in life.
The story of Rajesh and Swapna shows that it is possible to get out of debt trap by making some changes in the financials. The solution for the above story need not apply to another person’s situation. So let us look at the different ways in which one can get out of debt trap.
(1.) Consolidate the loans and take a single loan by pledging collateral. As the payment period can be longer and net interest rate will come down, the cash flows will become stronger.
(2.) Start reducing expenses. Reducing expenses will help to increase money available for loan repayments.
(3.) Identify additional income sources like part- time jobs. It will also increase the money available for loan repayments. If spouse is not working, she or he should try to take up some job to earn additional income.
(4.) If the repayments are very high and it is difficult to increase the income, then sell some assets and repay the loans.
(5.) Prepare a financial plan which will consider all the above and advice you on the best possible solution.
Prevention is better than cure. Read our 5 step guide to avoid debt traps.