Invest In India

Debt is an important tool available to every individual who is keen to build his assets. Being in debt is not a bad thing as long as you are taking steps to pay it off.

In India it is common to find individuals taking up debt in the form of mortgage, to fund consumption, for children’s education or for marriage or medical needs. The self-employed may borrow to start or expand their business.

However, while taking debt, one has to determine the limits for borrowings; having excessive debt can be a big stress factor and can even trigger a collapse of your finances. Here’s how an individual can implement a quick check up of his financial health and remedy the same.

How much to borrow?

All of us need to borrow at some time or the other to meet requirements for buying an asset or to meet a personal need. But how much should you borrow?

When borrowing, keep in mind a 50:25:25 ratio (monthly expenses, savings and debt) ratio of your income. Assume if you want to borrow for buying consumer durables or for events such as child’s education and marriage (irrespective of the emotion attached) it is always wise to restrict the EMI out go to 25 per cent of your net earnings. When debt is acquired to buy assets such as a house, this can be stretched to 35-40 per cent of your net salary.

Working out Ratios

You already have borrowings that you are repaying. The following ratios will help you assess if your finances are in good shape.

Liquidity ratio: Liquidity ratios are useful in analysing an individual ability to handle financial needs when faced with a sudden decline or interruption in income. A basic measure of liquidity is to compare your liquid assets and other financial assets to the monthly expenses that must be met. This ratio will indicate the number of months’ living expenses that your liquid assets can support.

For instance, if an individual has liquid assets for Rs 2 lakh and his monthly expenses are Rs 35,000, then he can manage his expenses for six months.

What are your liquid assets? Fixed deposits, bonds, equity, mutual funds and cash fit the bill. It is advisable to take bonds, equity and mutual fund investments at 50 per cent of their value, so that a sudden blip in the market doesn’t catch you by surprise.

Current ratio: It is important that adequate liquid assets are available to repay one’s debt. This ratio indicates how many times your liquid assets cover your short-term debt. If the current ratio is above one, it is considered good. Assume your liquid assets are Rs 3 lakh and your debt (not taking mortgages) is Rs 2.9 lakh; that a comfortable position. Mortgage debt should not be taken as a long-term debt.

Life insurance coverage ratio: This ratio will tell you how much insurance cover you need to meet your obligations.

To arrive at right ratio, your net worth is added to the death benefit your dependants may receive, if an unfortunate event happens. If this sum is divided by your salary, you get the quantum of coverage needed.

To figure out net worth, one should add the liquid assets, financial assets, equity assets, tangible assets (real estate, precious metals), personal assets (auto, jewellery) and deferred assets such provident fund, employee provident fund and pension plans.

A minimum coverage of 7-8 is best to protect the family in the event of untoward events.

Restructuring your debt

At a time when pay cuts and job losses are the order of the day, how do you deal with an interruption to your income, when you have a substantial EMI outgo? First list out all the outstanding debts you have and include the interest outgo. This will give you a clear picture of your current financial standing before beginning the restructuring process.

Here’s how you can rejig your loans:

Look out for the debt that backed by assets such as a house. If the debt is not managed carefully there is a possibility of the assets slipping out of your portfolio. If have taken a home loan at a higher cost, try to swap this for lower interest out go.

In the event of losing your job, it is possible to negotiate with your lender to increase the tenure of your loan. Such extensions will be granted provided the tenure does not exceed your retirement age.

By increasing the tenure of your loan, you can bring down your monthly outgo. Retain the option of reducing the term once again once your financial situation improves.

Soft loans

If you are not able to increase the tenure, then look out for soft loans from relatives, which help you tide over temporary difficulties and can be settled at a later date.

Another option that can be examined is letting out the mortgaged house and moving to a smaller house. Rent received from your home may allow a surplus that may help you pay off your EMI.

If you are servicing high-cost personal loans and other loans (business loan), try to avail a home equity loan (by pledging property). As this loan is backed by assets, you can bargain for better interest rates with your lender. If you have traditional insurance policies, you can also use the option of availing a loan against them. The interest outgo will be lower than other loans.

If your financial situation is not healthy, you can keep paying interest alone on the loan. The maturity proceeds of the policy will be paid after adjusting the outstanding principal. In such cases, the risk cover on the policy remains the same.

If you have credit outstandings in credit cards, apply for a credit card with a bank that offers balance transfer. Once you consolidate the outstandings, you can convert them into a personal loan, thereby reducing the interest out go.

If you roll over your credit on the card, the monthly interest outgo is close to 2.95 per cent (per month), but you can avail personal loans at much better rates.