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Business News/ Money / Calculators/  To deal with debt, rate and rank products
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To deal with debt, rate and rank products

Here's how to control debt that's gone overboard

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It is neither feasible nor desirable to live completely free of debt. You have multiple expenses and goals, and your income can go just so far. There are many large-ticket expenses, such as buying a house, which can be met more efficiently with debt. Used wisely, debt can actually improve your financial situation. Not only will you be able to get many of your goals off the ground, loans such as those for education can be used to improve your income earning capability, while the effect of leveraging enhances the benefits of using loans to buy appreciating assets such as real estate.

“Debt can help bridge the asset gap. It can dramatically enhance your net worth. Debt enables to fulfil need, responsibility and aspirations," said Kartik Jhaveri, director, Transcend Consulting (India) Pvt. Ltd.

Unfortunately, most people slip up when easy credit and loans are available, and use debt for non-essential needs as well. And then comes a stage when the debt starts undermining your financial stability. You may find that the debt repayments leave very little of your income for savings, or in extreme cases, income may fall short of your commitments. Both these situations indicate that debt levels have gone beyond what is desirable and need to be reduced.

Your aim should be to payoff loans so as to bring the debt down to a level that your income can comfortably service without jeopardizing other goals. Make a list of all your debt so that you can prioritize the repayment of the outstanding debt on the basis of what adds to your financial situation and what sets you back. To do this effectively, you need to understand the features of each outstanding loan.

All debt are not made equal. Some, like credit card outstanding, are high-cost debt, while a home mortgage is, typically, a lower-cost debt. Some, such as student loans and house mortgages, provide tax benefits that bring down the real cost of borrowing, while others, such as consumer and personal loans, have no special benefits.

Most loans are for a fixed period after which the lender can initiate action for recovery of dues, while others, such as credit card dues, can be extended by paying a penalty, albeit high. Some debt comes with the risk of losing the assets you bought using the loan if you don’t meet your repayment obligations, while others carry no risk of repossession.

“One needs to identify two kinds of loans—good loans and bad loans. Good loans help in building the asset base. These kinds of loans become fruitful in the longer run. But loans driven by consumerism are considered bad. If someone takes a loan to go for a holiday or to buy a new phone, it results in instalments stretching for long. If the EMI (equated monthly instalment) is more than 20% of income (for these), it is considered a bad loan," said Rishi Mehra, founder, Deal4loans.com.

The features of the debt you hold will influence how you prioritize it for meeting the regular repayment obligations as well as for paying it off, if you choose to do so. For example, if you are in a situation where your income is inadequate to service all your debt, you would first choose to provide for the EMIs on your home and probably car to avoid the risk of losing the assets. If you were looking at paying off your debt fully or partially to free your income for other goals, then you would first choose to pay off the debt that has the most negative impact on your finances. This would typically be the high cost debt such as credit card outstanding and personal loans.

“Debt in the unsecured segment should be paid on priority. A credit card debt should be paid first because the interest rate can go as high as 40%. There is a high penalty charge on personal loans, so those should be paid on priority. Then, one can proceed to paying home loans or car loans," said Mehra.

Take advantage of tax benefits, such as on education loans and home loans, for longer, and push such loans down on the prepayment list. A few debt are more flexible in terms of repayment and these could be used to your convenience. For example, repayment of student loans typically commence only once you are steadily employed. Use this provision to focus on other more pressing debt.

The quantum of the loan is another distinctive factor to categorize loans. Home loans are large loans that would take a sizeable amount of cash to pay off. Arranging the funds to prepay such a large sum early may mean that you have to put your other goals, such as the needs of children and retirement, on hold. So, unless you expect a large influx of cash, put off pre-payment of the home loan till other important goals are met.

Rank your debt in order of the effect it has on your financial situation, with debt that takes away from your wellbeing being higher up on the list and those that add to it coming lower down. Use this list to guide you when you make decisions on paying off debt.

Before you commit your income to bringing down your debt, do two things. One, set aside enough funds to meet any emergencies. And, two, make provisions to meet the minimum payment due on all your outstanding loans. This has to be done because the last thing you want is to have to turn to debt to fund any unexpected expense or to be declared a defaulter.

The next step is to decide how to discharge the outstanding debt that you have. You can opt to payoff some portion of every debt each month, and over a period of time pay it all off; or, you can deal with one debt at a time and target the one with the highest priority according to your list; or, you could decide to payoff the debt according to the outstanding balance first.

Dilshad Billimoria, chief financial planner and founder, Dilzer Consultants Pvt. Ltd, said, “First look at the rate of interest. Then, look at the frequency of being charged. For a home loan, for example, the frequency of interest charged is monthly. Try to pay the loan with highest outstanding balance first."

Choosing to payoff in the order of the list gives the most financial benefit since the higher priority ones are typically the high-cost debt. Debt with high interest rates can drag on for a long time if not fully paid in time. In these cases, the effect of compounding works to your detriment. Think of credit card outstanding balances that are not paid off fully each month.

However, paying off the debt with the smallest outstanding balance gives you the satisfaction of ticking a debt off the list and keeps you motivated enough to continue with the plan.

Whichever option you choose, the result will be that more and more of your income will get freed up as you reduce your debt and the repayment obligations come down. One must, however, have the discipline to use this additional income to retire more debt, and you will notice an escalating effect in repayment from one period to the next.

You may have let your finances drift and may now be burdened with multiple loans that are pulling down your financial wellbeing. Getting rid of all the debt that has been dragging you down will give you the space to focus on what really matters: your goals.

When you reach a comfortable level of debt (which doesn’t necessarily mean no debt), your money will be available to be used for productive purposes. After all, earning a return on that amount is much better than it going towards paying charges and penalties.

mintmoney@livemint.com

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Published: 29 Mar 2015, 08:20 PM IST
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