Beware of debt trap

I had written about handling cash surpluses last time. This time I will dwell upon the other side of the coin: Cash deficits. Today pursuing material happiness is no longer a passion confined to hedonists. It has become a national obsession with many consumers chanting the mantra of 'instant gratification'.

This has manifested in the impressive volume growth in certain emerging categories of white goods and consumer electronics, numerous foreign holidays, visits to expensive restaurants etc.

However, consumers with such new-found aspirations often encounter an old-fashioned problem i.e. the shortage of funds. While formerly it was a very valid reason for postponing consumption, the advent of retail-asset oriented friendly neighbourhood banks has altered the scene over the past five years or so.

Today, they are willing to fund every need and many young upwardly mobile consumers are willing to visit them for that purpose, often resorting to credit cards and personal loans to achieve their dreams.

I term these products "Weapons of Mass Destruction", as they have the potential to destroy the borrower by forcing them into a "debt-trap".

What is a debt-trap? It is a situation where interest payments and principal repayments take up increasing amount of our present and future income consequently impairing our ability to meet other important expenses and ultimately paving the way to bankruptcy.

How does one fall into a debt-trap?

One of the main causes is unlimited desires and limited income and injudicious use of various credit products on offer.

How can one be vigilant in these matters? Here are some factors to look out for in case of credit cards:

Banks advertise that you can enjoy 50 days of interest-free credit. However, this is not so. The 50-day period starts from the first day of the billing cycle and not from the date of purchases undertaken on the card. Hence, know your billing cycle and time your purchases accordingly.

Your credit card statement will state a certain minimum amount payable by the due date (usually 5 per cent of the amount). Read the fine print closely and you will find that the outstanding balance would attract an interest of 36-42 per cent per annum, which is the highest interest rate among the various credit products.

Worse, any further purchases made from the next cycle onwards will attract the same quantum of interest from day one and not from the end of that particular cycle.

Many banks offer to automatically convert your purchases into Equated Monthly Installments (EMI) at zero or low interest rates. However, once you account for hidden costs, the actual interest rate shoots up. Remember, there is no such animal as a zero interest EMI.

The best option to prevent yourself from falling prey to such tactics is to pay the outstanding amount in full before the due date.

Also, we are gradually entering into an era where timely repayment of such debt will lead us to getting loans at preferential rates. Hence, timely payment today could ensure a containment of your future interest burden.

The cash advance facility offered by cards is a very expensive form of credit as interest rates can spike to over 36 per cent per annum. Avoid it as far as possible.

People get attracted to personal loans as they are easily available, often just on the basis of your salary slip. The banks don't usually insist on a collateral and the end use of the money borrowed is not monitored. In order to avoid any resultant debt-trap, ensure that:

The cost of servicing such debt does not exceed 10-12 per cent of your monthly income.

Such loans are not taken for frivolous purposes such as holidays. Remember, the interest rate on such loans of 18 per cent plus is not low.

However, it may be worthwhile to take such loans for the purpose of retiring higher-cost credit card debts. Such refinancing is beneficial in the long run.

This could be prevented by:

Determine the amount of EMI you can afford before deciding the amount to be borrowed. Mortgage EMI payments should ideally not exceed 35 per cent of your monthly income. This figure should be lower if our income source is not very stable.

Desist from borrowing for a second home unless one has matching cash flows from rental receipts to offset the EMIs and maintenance charges.

Prefer a fixed rate loan to a floating rate loan (if the bank/housing finance company is willing to offer it) at least in the present economic scenario of rising interest rates. If a fixed rate loan is not available, a semi-fixed loan, where rates are reset once every few years, is the next best option.

The writer is vice-president, Parag Parikh Financial Advisory Services

HOW TO AVOID IT

Determine the amount of EMI you can afford before deciding the amount to be borrowed

Mortgage EMI payments should ideally not exceed 35 per cent of your monthly income

Desist from borrowing for a second home unless one has matching cash flows from rental receipts to offset the EMIs and maintenance charges

If a fixed rate loan is not available, a semi-fixed loan, where rates are reset once every few years, is the next best option