One of the very important aspect of Financial Planning is managing your debt. Many times it is found that investor give priority to wealth creation over debt management. But if don’t keep your debt under control it can create a huge impact on your long term wealth creation policy.
It is common for household to borrow in order to fund their aspirations and dreams. Human life is full of desires. Each new day brings new aspirations in our life. We try hard to fulfill those throughout our life. Some desires or aspirations can be fulfilled through our current income streams but some needs one time big cash flow to get it into reality. We may find it difficult to fulfill those desires from current income and as well as through our savings. For such desires we need help from “Debt”.
We usually borrow to fund our houses, cars and consumer durables. These are big ticket sized purchases. We may borrow for funding children marriages or family foreign vacations too. These purchases require huge amount of money at one go. Bank loans are available for such big purchases e.q. Home loan, Vehicle loan, Consumer durable loan, Personal loan etc. Several household also use credit card extensively for funding smaller purchases such as vacations, buying of luxury goods etc.
When we borrow what does it mean? To borrow is to use tomorrow’s income today. A portion of the tomorrow’s income has to be apportioned to repay the borrowing. This impacts the ability to save in future and in extreme cases can stress the ability to spend on essentials too. In other words it is very important to maintain your debt ratio in portion to your income.
Debt to Income Ratio: Measures if the earnings are enough to pay off the debt.
Debt-to-income ratio is the fraction of your monthly income you devote toward repaying debt. It is an indicator of the individual’s ability to manage the current obligations given the available income and parameter used by lenders to determine the eligibility of additional loans. It is calculated as
Monthly debt servicing commitment /Monthly income.
Debt servicing refers to all payments due to lenders whether as principal or interest.
Consider an Example where an individual has a monthly income of Rs 1.5 lakh and has a loan commitment of 60000 per month. The Debt to Income ratio is 60000/150000 = 40%
The debt-to-income ratio should ideally be lower than 30%. The ratio higher than 36% to 40 % is seen as excessive. A large portion of the income of the household is committed to meet these obligations and may affect their ability to meet regular expenses and savings. Obtaining loan in case of emergency may also become difficult. Any reduction in income will cause stress to the household’s finances.
Normally debt is divided into 2 types.
- Good debt: This debt helps the investor to create that asset which is appreciating in nature. It means value of the underlined asset will grow in the future. It ultimately helps to increase the overall wealth of the debtor in the long run. Good debt is a loan that has the potential to increase investor’s net worth.
- The Best example of this type of debt is Home loan: With this loan investor create a real estate asset which is considered as Growth Oriented Asset class (appreciation in capital value) and as well as Income Generating Asset class (regular rental income). Many investors follow the strategy of buying a house and living in it for a few decades before selling it at a profit. Commercial Real estate also can be an excellent source of cash flow and capital gains for investors.
- Small business enterprise loan: Many employees have an inner desire to own business to work on their own terms, where their efforts can generate money to them directly. The more they work, the more they can make money. If you are passionate and knowledgeable about the venture you want to start business loan can be your support to create your brand and ultimately wealth.
- Education loan: The general perception is that ,the more you are educated the more earning power you have.Better educated workers are more likely to be employed in good-paying jobs. An investment in a technical or college degree is likely to pay for itself within just a few years of the newly educated worker entering the workforce.
- Bad debts: This type of debt is called bad debt because it is used to buy those assets which are depreciating in nature. In other words, if it won’t go up in value or generate income, you shouldn’t go into debt to buy it. Some particularly notable items related to bad debt are
- Car loan: New cars, in particular, cost a lot of money. While you may need a vehicle to get yourself to work for your convince but many times people buy cars to how off their status. In this modern world owing a car ma be a necessity but owing a Sedan or ultra luxurious car is waste of money and particularly when you have purchased it by a loan. By the time you leave the car lot, the vehicle already is worth less than it was when you bought it.
- Cloths, consumables and electronic gadgets: The scale of Lifestyle keeps on increasing day by day. And we try to keep pace with this new lifestyle. Nowadays under the name of Lifestyle Expenses, we keep on spending on unnecessary things. We think these expenses are mandatory to keep our Status intact. Branded clothes, luxurious vacations, the latest smart phones, electronic appliances, and lavish marriages are all items commonly bought with borrowed money. Every penny spent in interest on these items is money that could have been used more wisely elsewhere.
- Credit cards: These are one of the worst forms of bad debt. The interest rates charged are often significantly higher than the rates on consumer loan close to whopping 42% p.a. and the payment schedules are arranged to maximize costs for the consumer. Credit card loan is an example of rolling credit. Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit. You should use credit card very wisely or instead use debit card.
Evaluating which assets or expenses can be funded by borrowings is very important task.
Debt Management is a process where households are required to know how to finance their assets, how much to borrow, how to provide for repayments, how to ensure that credit scores are not unfavorably impacted.
Sometimes, excessive borrowings may lead a household into a debt trap. Such borrowers need counseling and handholding to be able to get out of the debt. Sometimes assets may have to be liquidated to pay off debts. Debt management focuses on repaying the highest interest loan on priority. Financial Advisors play crucial roles in Debt management. Their expert advice help households to deal with their borrowings taking into account their need and ability to repay debt.
It is always recommended to hire professional Investment Advisor who can help to in wealth creation as well as in managing your debt.