DEBT MANAGEMENT AND LOANS

DEBT MANAGEMENT AND LOANS (Part 1)

• Definition of Debt: Debt is used to finance goals when available funds (self-funding) are inadequate. It can be used for acquiring assets such as a house, education, or other investments.
• Role of Debt in Cash Flow Management: Debt plays a crucial role in cash flow management, and its impact depends on the financial situation of each household. A good indicator is the Debt-to-Income Ratio (DTI), which measures the ability to meet obligations arising from debt with available income.
• Leverage and Debt Counselling: Leverage refers to the use of debt to increase the potential return on an investment. Debt counselling is essential to consider various aspects when advising clients on debt, including the purpose of the debt, interest rate, loan amount, and repayment terms.
• Key Concepts:
  • Debt Servicing Ratio: The ratio of debt servicing to income, which should be kept low to avoid disrupting cash flow management.
  • Consumption Expenditure: Expenses that do not create an asset that generates further income, such as dining out or buying clothes.
  • Investment Expenditure: Expenses that lead to the creation of an asset, such as buying a bond or property.
  • Windfalls: Unexpected income, such as bonuses or inheritances, which should be allocated wisely to future needs or debt repayment.
• Importance of Budgeting: A budget helps allocate income between current and future needs, prioritizing essential expenses, investment expenditure, and debt servicing. It's essential to identify and eliminate unnecessary expenses to ensure efficient cash flow management.
• Strategies for Debt Management:
  • Prioritize Needs over Wants: Distinguish between essential and discretionary expenses.
  • Track Expenses: Regularly monitor expenses to avoid overspending.
  • Allocate Windfalls Wisely: Use unexpected income to prepay loans or invest in assets.
  • Consider Debt Counselling: Seek advice on managing debt and creating a personalized plan.

DEBT MANAGEMENT AND LOANS (Part 2)

• Debt Management: Debt should not be used to finance regular expenses, as it can lead to a debt trap. Taking short-term debt to tide over temporary liquidity problems may be fine, as long as the borrower knows the risk and has a plan to repay the debt as soon as possible.
• Cost of Debt: The higher the rate of interest at which money is borrowed, the more will be the outgo in servicing the debt. Secured loans (e.g., mortgages, education loans) are relatively cheaper, while unsecured loans (e.g., personal loans, credit card debt) are very expensive and must be used with caution.
• Maturity of Debt: The shorter the tenor of the loan, the more will be the periodic repayment, putting pressure on available income. Loan tenor should be decided keeping in mind the repayment capacity of the borrower.
• Debt Re-scheduling: If a borrower is unable to manage debt repayments, potential solutions include:
  • Ranking debt in order of cost and dealing with the costliest debt first
  • Selling assets to pre-pay debt
  • Re-financing with a cheaper loan
  • Extending the loan tenor
  • Informing the lender about the problem and exploring a revised loan schedule

Key Concepts in Debt Management

• Credit Score: A number assigned to each individual by a credit information bureau based on their credit behavior and repayment history.
• Credit Bureaus: Licensed by the RBI and governed by the Credit Information Companies (Regulation) Act, 2005, to assess an individual's credit and financial health.
• Debt Servicing Requirements: Calculating the amount required to service debt, including interest and principal payments.
• Responsible Borrowing: Borrowing only what can be afforded, avoiding excessive debt, and using debt responsibly to finance value-appreciating assets.

Types of Loans

• Secured Loans: Backed by an asset as security (e.g., housing loans, vehicle loans, gold loans), with relatively lower interest rates.
• Unsecured Loans: Without any security (e.g., personal loans, credit card debt), with higher interest rates due to higher risk.
• Fixed Rate Loans: Loans with a fixed interest rate for the entire duration, useful when interest rates are low.
• Variable or Floating Rate Loans: Loans with an interest rate that can change over time, also known as floating rate loans.

DEBT MANAGEMENT AND LOANS (Part 3)

• Variable Rate Loans: These loans have interest rates that change or get reset periodically with the changes to the benchmark rate to which this is linked. Variable rate loans can be linked to an external benchmark like the repo rate or an external bank benchmark rate like the Marginal Cost of Lending Rate (MCLR).
• Home Equity Loan: Also called a loan against property (LAP), where the borrower uses their home or any other real estate as collateral for the purpose of taking a loan.
• Hire Purchase: An agreement where an individual agrees to buy a certain asset by paying instalments over a period of time. The person paying the amounts becomes the owner of the asset when the final instalment is paid.
• Lease: A contractual agreement where the owner of an asset (the lessor) allows another person (the lessee) to use the asset for a certain period of time in exchange for the payment of lease.
• Amortisation: The process of repaying the capital borrowed over a period of time through fixed payments, also known as Equated Monthly Instalments (EMI).
• Refinancing: The act of repaying an existing loan by taking another loan, either to extend the duration of the loan or lower the interest cost.
• Prepayment: Paying back the capital before the specified time, which reduces the outstanding amount of the loan and the remaining EMI period.
• Pre-EMI Interest: Monthly payments that include only the interest component being repaid, usually present for house properties that are not yet complete.
• Moratorium: A period where repayments on a loan are stopped temporarily due to extraordinary factors, and the interest meter continues, increasing the borrower's dues.
• Mortgage: A debt instrument backed by a specified property that the borrower has to pay back over a specified time period through regular payments.
• Pledge: An asset held as security on a contract, which can be sold by the lender in case the borrower is not able to repay the amount.
• Hypothecation: Creating a charge against an asset, where the asset remains with the borrower, and if there is a default, the lender will have to take possession of the asset and then sell it.

Types of Borrowing

• Home Loan: A loan taken for the purchase of a house property, which can be for a constructed or under-construction property.
• Education Loan: A loan used to fund the cost of education, with repayment usually starting after the completion of the education course or when the person starts earning.
• Vehicle Loan: A loan taken for the purpose of purchasing a vehicle, with the vehicle being hypothecated against the loan.
• Business Loan: A loan taken for the purpose of conducting business or profession, with the lending institution looking at the financial position of the business and its ability to repay the amount.
• Personal Loan: A loan that can be used for any purpose, without any security, and is often more expensive than a normal loan.

DEBT MANAGEMENT AND LOANS (Part 4)

• Introduction to Debt Management: Debt management involves being careful when using loans backed by assets, as they can be easy to get but difficult to repay.
• Types of Loans: There are various types of loans, including:
  • Credit Card Debt: An unsecured loan with a high interest rate, making it an expensive way to borrow.
  • Overdraft: A facility that allows individuals to use more than the balance in their account, usually backed by a fixed deposit or other security.
  • Loan against Securities, Gold, Property, etc.: A secured loan where the individual uses an asset as collateral to get a loan.
  • P2P Loans: Peer-to-peer loans, where one person lends to another directly, often with high interest rates and unsecured credit.
• Understanding Loan Calculations:
  • Equated Monthly Instalment (EMI): Can be calculated using the =pmt function in MS Excel.
  • Debt Servicing Ratio: The ratio of debt repayment to income, which should be managed carefully to avoid financial stress.
• Loan Restructuring:
  • Definition: A change in the conditions of an existing loan, such as reducing the EMI or increasing the repayment period.
  • Importance: Helps borrowers manage financial stress and avoid defaulting on loans.
  • Present Value Calculations: Used to determine the actual value of loan restructuring, taking into account the present value of future payments.
• Repayment Schedules with Varying Interest Rates:
  • Importance: Understanding the repayment schedule is crucial, as it affects the amount paid towards interest and capital.
  • PPMT Function: Used in Excel to calculate the principal component of the EMI, helping individuals track their loan repayment.

DEBT MANAGEMENT AND LOANS (Part 5)

• Loan Repayment: The kind of money going towards repaying the capital borrowed can be calculated using the PPMT function, while the interest component can be calculated using the IPMT function.
• Example: For a loan of Rs. 10 lakh with an interest rate of 7% and a repayment period of 10 years in monthly installments, the EMI would be Rs. 11,610. The principal payment for the first month would be Rs. 5,777, and the interest component would be Rs. 5,833.

Criteria to Evaluate Loans

• Interest Rate: A lower interest rate is preferable, and the method of calculation (reducing balance or fixed capital) is also important.
• Interest Rate Reset Period: A shorter period allows for quicker adjustments to interest rate changes.
• Expenses: Processing fees, legal charges, and other expenses can increase the cost of the loan.
• Loan Tenure: A longer tenure may be favorable for those who want to reduce their EMI.
• Benchmark: Loans linked to external benchmarks like the repo rate are more transparent.

Opting for Change in EMI or Change in Tenure

• Floating Rate Loans: Changes in the linked benchmark can lead to changes in the interest rate, and borrowers can choose to change their EMI or loan tenure.
• Choice: Borrowers can opt to keep their EMI the same and change their loan tenure or vice versa.

Invest or Pay Off Outstanding Loan

• Factors to Consider: Loan burden, interest rate, investment earnings, and asset class.
• Decision: If the interest rate on the loan is high, it may be better to pay off the loan. If the investment earnings are high, it may be better to invest.

Strategies to Reduce Debt Faster

• Avalanche: Pay off loans with the highest interest rates first to reduce the interest burden.
• Snowball: Pay off loans with the lowest amounts first to achieve a sense of success.
• Example: If an individual has multiple loans with different interest rates, the avalanche strategy would prioritize paying off the loan with the highest interest rate first.

DEBT MANAGEMENT AND LOANS (Part 6)

• Debt Repayment Strategies: There are several approaches to repaying debt, including the snowball, avalanche, and blizzard methods.
• Snowball Strategy: The goal is to gain momentum by paying off the smallest loan first and then rolling the savings into the next loan repayment.
• Avalanche Method: Involves paying off the loan with the highest interest rate first to minimize the amount of interest paid.
• Blizzard Approach: A combination of the snowball and avalanche methods, starting with the snowball method to gain momentum and then switching to the avalanche method to pay off the highest interest rate debt.

Key characteristics of each method:

• Snowball Method:
  • Pays off the smallest loan first
  • Gains momentum as each loan is paid off
  • Can be a motivational strategy
• Avalanche Method:
  • Pays off the loan with the highest interest rate first
  • Minimizes the amount of interest paid
  • May take longer to gain momentum
• Blizzard Approach:
  • Combines the snowball and avalanche methods
  • Starts with the snowball method to gain momentum
  • Switches to the avalanche method to pay off the highest interest rate debt

To determine the best approach, it's essential to have the exact amount outstanding and interest rates on the loans. For example, paying off a credit card debt first (smallest amount), followed by a personal loan (highest interest rate), and then a car loan and housing loan.

Sample Questions:

1. Not a part of the financial planning process:
   • a. Setting goals
   • b. Monitoring
   • c. Develop financial planning recommendations
   • d. Financing the investments
2. Avalanche mode of repayment:
   • a. Loan with the highest amount
   • b. Loan with the lowest amount
   • c. Loan with the highest interest rate
   • d. Loan with the lowest interest rate
3. P2P lending process:
   • a. A bank
   • b. A financial institution
   • c. An individual
   • d. A fund
4. Car loan:
   • a. Hypothecation
   • b. Pledge
   • c. Mortgage
   • d. Moratorium
5. Unsecured loan:
   • a. Home loan
   • b. Car loan
   • c. Gold loan
   • d. Personal loan