PersonalFN's

We believe by signing up for the initiative, you too endeavour to develop the skills needed to understand the nuances of personal finance and be money-wise.

Module VII: How To Ensure That Your Loans Do Not Become A Burden

Session 23: How To Get Out Of A Debt Trap (A Case Study)

Many avail various types of loans at some point in time in life.

Some loans such as home loan are considered good, because it leads to creation of an appreciating asset, plus you also enjoy a tax benefit.

However some loans such as car loan, credit card loan etc. are considered bad, as they lead to buying s depreciating assets, and may be bad for your personal finances.

Today, in the era of consumerism, even mobile phones, TV, Refrigerator, laptops, tablets, home theatres, amongst host of other such items are bought on easy credit - either through EMI facility on credit cards or teaser schemes floated by NBFCs.

But then the question is, are these easy finance options (which lure you), good for your personal finances?

Well, to answer that, in most cases no! They end up damaging your financial health, as very often many get into debt-trap very quickly, leading to a financial mess.

Same was the case with one of our client, Mr Raghu (named changed to protect privacy) who had almost all the type of loans and didn't know how to settle these. He was in a financial mess!

He approached us and here's how we helped him to get out of a debt-trap...

Mr Raghu, a 32 year old married individual was earning Rs 75,000 per month. His expenses were Rs 40,000 per month, which did not include EMI on various loans.

At the end of the month he used to be left with a surplus of Rs 35,000, out of which he had to service his EMIs and invest for his future financial goals.

So, you can see that Mr Raghu had very few assets, totalling to Rs 27.93 lakhs out of which Residential Flat comprises 90% of his total assets. Since he is staying in this flat, it could not be sold. His investments in EPF and PPF could not be liquidated and he is maintaining some amount of cash and Fixed Deposits (FDs) for contingency purpose.

As far as liabilities are concerned, Mr. Raghu had several of them, of which Home Loan was taken for his residential flat (which he is currently self-occupying).

He had also taken a personal loan for furnishing this very house and the rate of interest, which he was paying on this loan, was 14% p.a.

He bought a small car on loan for which he was paying interest at the rate of 11.50% p.a.

His credit card loans led by his impulsive buying were carrying a worryingly high interest rate of 30.00% p.a. and 36.00% p.a.

He had also taken an interest-free hand loan from his brother for the down payment of his flat which can be repaid anytime within next 3 years.

And here was Raghu's Concern!

He had a surplus of just Rs 35,000 p.m. while he had total EMIs of Rs 39,468. So how does he manage his cash flows to pay-off liabilities and which liability need to be settled first.

We recommended him...

1. Do not make any further impulsive buying on credit cards or otherwise.

2. Avoid unnecessary expenses such as dinning out and movies, at least till the financial mess is resolved.

3. Equity Mutual Funds worth Rs 75,000 which had been invested in thematic and sectorial funds were asked to be redeemed. He was also asked not to further invest in such funds as these are high risk investment proposition and such funds perform only when underlying respective sectors are doing well.

4. Out of redemption proceeds of Equity Mutual Funds, we aksed him to first pay-off Credit Card Loan 2 of Rs 50,000 as this had the highest rate of interest of 36% p.a. Secondly, we advised him to pay-off Credit Card Loan 1 of Rs 40,000 as this had the next highest rate of interest of 30% p.a. This needed to be paid out from the balance of Rs 25,000 from the proceeds of equity mutual funds (Rs 75,000 total redemption value - Rs 50,000 paid for credit card loan 1) and Rs 15,000 from Cash in Bank.

5. Bear a higher EMI of Rs. 15,000 p.m. on Personal Loan carrying the rate of interest of 14% p.a. Increasing the EMI ensured that personal loan will be paid off within next 11 months rather than keeping it pending for 18 months as per his earlier liability structure. By doing so, he was able to save interest for 7 months at least.

And what did we achieve?

✓ In next 11 months all his high interest rate liabilities were paid-off

✓ The total EMIs came down from Rs 39,468 to Rs 19,860,

✓ A surplus of Rs 15,140 per month was generated through this after all EMIs (Rs 35,000 total Surplus after all expenses but before EMIs - Rs 19,860 total EMIs)

The surplus of Rs 15,140 p.m. was asked to be utilized for...

1. Creating at least 3 months of Contingency Reserve - He had around Rs 55,000 in cash in bank after paying Rs 15,000 towards Credit Card Loan 1 from Rs 70,000 in cash in bank initially. Additionally, he already holds Rs 30,000 in FD. So effectively his total contingency reserve was placed at Rs 85,000 (Rs 55,000 + Rs 30,000) but we recommended him to increase it to at least 3 months of expenses (3 months of contingency was advised since he had very limited surplus otherwise minimum of 6 months of contingency is recommended). You see, since his total expenses including EMIs was Rs 59,860, he was asked to create a total contingency reserve of Rs 1,80,000. Deficit of Rs 95,000 was to be funded from Rs 5,000 p.m. surplus starting 12th month for next 19 months i.e. till 30 month.

2. Accumulating and thereafter repaying interest-free hand loan taken from brother - Starting from 12th month, he was asked to start a SIP of Rs 3,740 in a liquid fund for 25 months so that he will have Rs 1 lakh after 3 years from now to pay off interest free hand loan from brother. (Interest assumed in a Liquid Fund at 6.50% p.a.)

3. Investing for future financial goals - The balance surplus of Rs 6,400 from 12th to 30th month and Rs 11,400 from 31st to 36th month was recommended to be invested across equity, debt & gold (through the mutual funds) for other long term financial goals.

Increasing the EMI on home loans was not recommended as he was enjoying tax benefit on both - principal as well as interest payment. Likewise, increasing car loan EMI was not advised because he had very limited surplus. If he were to increase his EMI, it would not have left him with any surplus to invest and create wealth to meet his other financial goals.

So, this way you too need to do a prudent assessment of liabilities to get of a debt-trap.

Finally, here are a few...

• Avoid taking loans for depreciating assets.

• Your total EMIs should never be more than 40% of your monthly salary.

• Never go for credit card loans as the rate of interest charged on it, is the highest.

• Avoid getting lured to easy finance options available through credit card EMIs or teaser schemes floated by NBFCs, as this might lead to impulsive buying.

• Rate of interest charged on personal loan is high, so try to avoid it until and unless it is inevitable.

• Ensure that when you're taking a loan, you aren't jeopardising your family's long-term wellbeing.

Disclaimer: This is for Private Circulation only and is not for sale. The content is only for information purposes and Quantum Information Services Private Limited (PersonalFN) is not providing any professional/investment advice through it. It does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities. PersonalFN disclaims warranty of any kind, whether express or implied, as to any matter/content contained herein, including without limitation the implied warranties of merchantability and fitness for a particular purpose. PersonalFN and its subsidiaries / affiliates / sponsors / trustee or their officers, employees, personnel, directors will not be responsible for any direct/indirect loss or liability incurred by the user as a consequence of his or any other person on his behalf taking any investment decisions based on the content herein. It should be used at the user's own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary. PersonalFN does not warrant completeness or accuracy of any information published herein. All intellectual property rights emerging from this transcript content are and shall remain with PersonalFN. This is for your personal use and you shall not resell, copy, or redistribute this transcript, or use it for any commercial purpose. All names and situations depicted in the transcript content are purely fictional and serve the purpose of illustration only. Any resemblance between the illustrations and any persons living or dead is purely coincidental.