Sanket Dhanorkar | Dec 29, 2014, 06.10AM IST | Times of India
Borrowers typically have horror stories to tell about loan tenures that have been extended till retirement, credit cards charging astronomical amounts and harassment by lenders due to missed EMIs. If you also find it difficult to repay your loans, here are some strategies that can help you manage your debt situation without stressing your wallet.
Repay high interest loans first
As a first step, make a list of all outstanding loans and then identify the ones that need to be tackled first. Ideally, start by repaying the costliest loan, such as credit cards and personal loans. Pay the maximum amount you can afford against the high-cost loan without jeopardising the repayment of the other loans. Once you have cleared the costly debt, move to the next one. Also known as the ‘debt avalanche’, this strategy minimises the total interest paid on all loans. But this repayment should not be at the cost of the regular EMIs on other loans. Those must continue as well.
While prioritising repayments, also consider the tax benefits on some loans. For instance, the interest paid on an education loan is fully tax deductible. If you factor in the tax benefits in the 30% tax slab, an education loan that charges 12% effectively costs 8.5%. Similarly, tax benefits bring down the actual cost of a home loan.
Increase repayments with rise in income
One simple way to repay your loans faster is to bump up the EMI with every rise in your income. Assuming that a borrower gets an 8% raise, he can easily increase his EMIs by 5%. The EMI for a 20-year home loan of `20 lakh at 11% rate of interest comes to `20,644. The borrower should increase it by around `1,000 every year. Don’t underestimate the impact of this modest increase. Even a 5% increase in EMI ends the 20-year loan in just 12 years (see table). It helps the borrower save almost `12 lakh in interest.
|Repay more as income rises|
|Even a small 5% increase in the EMI every year can reduce the home loan tenure by about 8 years|
|Amount : 20lacs||Term : 20 years||Rate : 11%|
|Year||EMI (Rs)||Remaining Tenure|
|1||20644||20 years||The borrower can reduce his tenure by 8 years vy increasing the EMI by 5% per year|
|2||21676||16 years 5 months|
|3||22760||12 years 11 months|
|4||23898||10 years 10 months||If the EMI is increased by 10% the tenure will be reduced by 10 years|
|6||26347||7 years 5 months|
|7||27665||6 years||Even a minute 2% increase in EMI can reduce tenure by nearly 5 years|
|8||29048||4 years 8 months|
|9||30500||3 years 6 months|
|10||32025||2 years 4 months||If the home loan interest rates come down then the reduction in tenure will be much more|
|11||33627||1 year 3 months|
Use windfall gains to repay costly debt
Received a fat bonus? Do not splurge on the lastest smart phone or newest plasma TV. Use the money to pay down your debt aggressively. Windfall gains, such as income tax refunds, maturity proceeds from life insurance policies and bonds, should be used to pay costly loans like credit card debt or personal loans. However, the lender may levy a prepayment penalty of up to 2% of the outstanding loan amount. While the RBI does not allow banks to levy a prepayment penalty on housing loans with floating rate interest, many banks do so for fixed rate home loans. Lending institutions normally do not charge any prepayment penalty if the amount paid does not exceed 25% of the outstanding loan at the beginning of the year.
Convert card dues to EMIs
Credit cards are convenient and give you interes- free credit for up to 50 days. However, they can also burn a hole in your wallet if you are a reckless spender. If you regularly roll over the credit card dues, you shell out 3-3.6% interest on the outstanding balance. In a year, this adds up to a hefty 36-44%. If you have run up a huge credit card bill and are unable to pay it at one go, ask the credit card company to convert your dues into EMIs. Most companies are willing to let customers pay down large balances in 6-12 EMIs. If the sum is big, they may even extend it to 24 months. However, if you miss even a single EMI, the rate will increase to the regular rate of interest your credit card charges. You can also take a personal loan. These are costly but will still be cheaper than the 36-44% you pay on the credit card rollover.
Use investments to repay debt
If your debt situation becomes bad, you can use your existing investments to make it better. You can borrow against your life insurance policy or from the PPF to pay off your loans. The PPF allows the investor to take a loan against the balance from the third financial year of investment, and the same is to be repaid within three years. The maximum loan one can take is up to 25% of the balance at the end of the previous year. The rate of interest charged on the loan is 2% more than the prevailing PPF interest rate. However, one should withdraw from one’s PPF or Provident Fund accounts to pay off debts only in extreme situations. These are long-term investments which should ideally be kept untouched to ensure that compounding works its magic.
Consolidate or refinance
If you have multiple loans, consider taking a secured loan against an asset to repay them. Loans taken against property are much cheaper and can replace costly loans. You can choose a tenure that is comfortable and an EMI that is affordable. Interest rates are likely to change soon. Keep track of what is the going rate in the home loan market. If you can get a better rate, have your loan refinanced. This will involve a one-time cost, which is typically around 1-2% of the outstanding loan, with a cap ranging between `25,000 and `50,000 depending on the bank. The gain from this refinancing should be higher compared to the charges you pay. As a rule, if the prevailing rate of interest payable on your home loan is 1% more than the interest rate on offer in the market, you should consider refinancing your home loan. Beware of loan agents asking you to shift your floating rate loan to a fixed rate one at this point. With rates expected to climb down, you may lose out if you switch to a fixed rate loan at this stage.
Make lifestyle changes
It is often the little things that go a long way in keeping your finances in fine fettle. While so far we have discussed different ways in which you could reduce your loan burden, you may also need to make some lifestyle adjustments to accommodate your loan repayments and ensure you have enough money to pay higher EMIs. A lifestyle change is needed until all debts are repaid. This means cutting down on luxuries and unwanted spending. Go slow on movie shows, dining out and weekend getaways. Keep the credit card locked up when you go to the mall and try to make purchases with cash.
In extreme cases, you could also get your credit card company to lower your spending limit. Most importantly, cut down on taking fresh loans unless these are taken to prepay existing, costlier loans. Automatically debit your repayment dues to your bank account. In this way, you eliminate the possibility of missing the payment by mistake. Remember, paying after the due date attracts late fee and impacts your credit score negatively.
Lastly, do not feel shy to cry out for help. If you are unable to figure out a way out of your debt hole, approach a debt counselling centre, which offer free advice. These are actively engaged in helping borrowers facing problems with their loans.
Source : http://goo.gl/8hB0ez