Debt Management and Loans

1Why people borrow

Debt finances goals when own funds are not enough: few people could buy a house from savings before retirement. Lenders protect themselves with a charge, pledge or mortgage on the property (hence "mortgages"). Other debt: auto loans, consumer durable credit, personal loans and credit card balances. Debt costs interest and must be repaid, so it depends on whether income can bear the extra outgo.

Debt is not always bad: a home loan is fine; leverage can raise returns (the Modigliani–Miller idea); an education loan may be better than raiding a retirement fund, since future income repays it while existing investments keep compounding. Short-term debt can also bridge emergencies or cash mismatches.

Remember

• Judge debt by its purpose; keep investments compounding.

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2Debt and cash flow; consumption versus investment spending

How much debt is right depends on the household. The debt-to-income (DTI) ratio measures ability to service debt; there is no single "optimal" level, but lower is better and lenders set their own limits.

Example Salary ₹15,000, debt servicing ₹7,500 → DTI 50%, far too high: little left for expenses, emergencies or investing.

Higher rates and larger loans both raise repayments. Keep debt servicing low so there is room to borrow in a crisis.

Consumption expenditure creates no income-generating asset (restaurants, clothes, salons). Investment expenditure creates an asset that can generate income (a bond, a property). Education may look like consumption but can raise family income, so prioritise it. Use a budget that separates mandatory, essential and discretionary items, and allocate savings to goals before discretionary spending (for example SIPs debited automatically from salary). Change the habit from income − expenses = savings to income − savings = expenses.

Remember

• Spend after saving, not save after spending.

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3Plugging budget holes and handling windfalls

Common budget errors: confusing essential and discretionary expenses, over-allocating, not "paying yourself first", and not tracking spending. Advisers should get clients to record every expense above a threshold (₹500 for some, ₹5,000 for others). A month-end summary often reveals big avoidable spending (eating out paid by card, needless gadget upgrades).

Excluding unusual items (an uninsured hospitalisation), group outflows into retirement contributions, loan servicing, essential and lifestyle expenses, and set limits with the family. Essentials do not shrink much; lifestyle spending can. Zero-based budgeting, taking every expense from scratch rather than adjusting last year's figures, works for households too.

Windfalls (big bonus, inheritance, lottery): save a healthy portion, since the family managed without it, and consider prepaying loans. It need not be invested at once; park it in risk-free liquid assets until a decision is made. Never rely on windfalls to rescue bad finances.

Remember

• Zero-based budgeting questions every expense.
• Park windfalls safely, then decide.

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4Debt counselling: purpose, cost, maturity and rescheduling

Purpose: borrow ideally for appreciating assets (property) or to raise earning power (an education loan to upskill). Borrowing for risky investments, such as margin funding for shares, magnifies losses. Never borrow for regular expenses: that means living beyond your means and heading for a debt trap. Short-term borrowing for temporary liquidity is acceptable with a repayment plan.

Cost: secured loans (mortgages) and education loans are cheaper; personal loans and credit cards are very expensive. A card is interest-free only if paid in full by the due date; carrying a balance is revolving credit.

Example 3% a month on a card = (1.03)¹² − 1 ≈ 42.6% a year. Informal moneylenders may charge 60–80% a year or 5% a month.

Maturity: shorter tenor means higher EMIs (pressure on income) even at low rates; longer tenor means more total interest. Set tenor by repayment capacity, using DTI.

Rescheduling when repayments become unmanageable:

• rank debts by cost and clear the costliest first (credit cards, personal loans); low-cost, tax-advantaged home and education loans can wait;
• sell the financed asset (if it has reasonable value) to prepay, allowing for prepayment charges;
• refinance with cheaper debt (for example a credit card balance transfer);
• extend the tenor to cut EMIs (but total interest rises);
• otherwise approach the lender for a revised schedule, which hurts the credit score.

Remember

• Never borrow to fund regular expenses.
• Clear the costliest debt first.

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5Credit bureaus and credit scores

A credit score is assigned by a credit information company, licensed by the RBI under the Credit Information Companies (Regulation) Act, 2005, based on outstanding loans, repayment behaviour, credit utilisation, the mix of secured and unsecured debt and other factors reported monthly by lenders. The CIBIL TransUnion score ranges from 300 to 900. Banks, HFCs and NBFCs use it for approval, rates and limits.

Build a good score by: paying on time; keeping utilisation low; avoiding too much unsecured debt; keeping a mix of secured and unsecured credit; making credit enquiries only when needed; and remembering that loans where you are a joint holder or guarantor count too. Review the report periodically to correct errors. Access it from a licensed bureau (online) or genuine lender tie-ups, being wary of scams.

RBI rules on free reports: everyone is entitled to one free full credit report a year (calendar year, January–December) from each bureau (CIBIL, Experian, CRIF High Mark, Equifax), the same report lenders see, in electronic form, after authentication (PAN, UID), with the ability to correct errors. It typically shows repayment history for the past 2–3 years. Companies have credit reports too.

Remember

• CIBIL score: 300–900. One free report a year from each bureau.

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6Responsible borrowing; secured and unsecured loans

Never borrow more than you can afford; avoid a flashy lifestyle you cannot sustain; buy only what you can pay for; pay credit cards in full by the due date; borrow for appreciating, income-yielding assets; and avoid taking on too many loans at once.

Secured loans are backed by an asset: home loans (the house is mortgaged; ownership stays with the borrower, but the lender can sell on default), vehicle loans, gold loans, loans against securities. Lower interest rates. Unsecured loans rely only on the borrower's promise: personal loans and credit card dues, at much higher rates. Use secured loans for long-term assets and keep unsecured debt minimal.

Remember

• Security lowers the interest rate.

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7Loan terms

• Fixed rate: the rate is fixed for the whole term; cost is certain; useful to lock in low rates.
• Floating (variable) rate: reset periodically against a benchmark, either an external benchmark such as the repo rate or an internal one such as MCLR; preferred for long loans when rates are expected to fall.
• Home equity loan / loan against property (LAP): borrowing against property one owns.
• Hire purchase: pay instalments; you become the owner after the last instalment.
• Lease: the lessor keeps ownership; the lessee uses the asset for a fee and never becomes owner (common for company vehicles).
• Amortisation: repaying through equal EMIs; early EMIs are mostly interest, later ones mostly principal.
• Refinancing: taking a new loan (usually cheaper) to repay an old one; worthwhile for large, long loans with a significant rate gap.
• Prepayment: repaying principal early, reducing the outstanding and remaining tenure. Some loans restrict or charge for it (for example car loans); the RBI does not allow prepayment charges on floating-rate home loans from banks (as the workbook states).
• Pre-EMI interest: interest-only payments while an under-construction property's loan is partly disbursed; full EMIs start later.
• Moratorium: a temporary pause in repayments for extraordinary reasons (for example COVID-19); not a default and does not hurt the credit score, but interest keeps accruing (compounding), and missed EMIs must be repaid later.
• Mortgage: a loan secured on immovable property.
• Pledge: a movable asset is held by the lender until repayment.
• Hypothecation: a charge where the asset stays with the borrower (car loans); on default the lender must repossess it first.

Remember

• Pledge: lender holds the asset. Hypothecation: borrower keeps it. Mortgage: immovable property.
• Moratorium: no default, but interest continues.

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8Types of borrowing

• Home loan: for a ready or under-construction house, for living or investment; long tenors of 30–35 years (within working-age limits); the property is security and the lender keeps the documents.
• Education loan: usually 5–8 years; repayment typically starts after the course ends or once the student starts earning, whichever is earlier; interest accrues meanwhile; parent or student may repay.
• Vehicle loan: 3–7 years, the vehicle hypothecated; longer tenor lowers the EMI but raises interest on a depreciating asset.
• Business loan: for running a business; lenders assess working capital needs, turnover ratios and the balance sheet; may be secured by assets or hypothecated stock, often with an overall limit.
• Personal loan: for any purpose, unsecured, easy to get, expensive.
• Credit card debt: short-term credit up to a limit; free if paid by the due date; otherwise the most expensive (and easiest) way to borrow, leading to a revolving credit trap.
• Overdraft: drawing beyond the account balance up to a limit, usually secured (for example against an FD), with interest only on the amount and period overdrawn; deposits automatically reduce it; mostly used by businesses.
• Loans against securities, gold or property: a secured loan up to an RBI-permitted percentage of the asset's value; if prices fall sharply, the lender can ask for more margin. Better than personal loans or cards if you have such assets.
• P2P (peer-to-peer) loans: individuals lend directly to individuals through platforms; unsecured, with only basic checks, so high risk and high rates, usually small and short-term.

Remember

• Education loan repayment: after the course or first earnings, whichever is earlier.
• In P2P lending, the lender is an individual.

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9Loan calculations

EMIs come from Excel's PMT, with rate and periods matched to the payment cycle.

Example ₹1 lakh at 12% a year for 5 years: annual instalment ≈ ₹27,741 (≈ ₹2,312 a month if paid monthly on an annual rest). At 1% a month for 60 months, the EMI is ₹2,224.

Lenders use "rest" for the interest-charging cycle, which may differ from the payment cycle. With an annual rest and monthly payments, the lender credits repayments only once a year, so the effective cost is higher than the quoted rate.

Example With income ₹10,000, an EMI of ₹2,224 gives a DTI of 22.2%. Extending to 6 years cuts the EMI to about ₹1,955 (19.6%). Another ₹1,000 loan takes DTI to about 29.6%.

DTI can be reduced by a longer tenor, a lower rate or a smaller loan.

Remember

• Annual rest with monthly payments raises the effective cost.

10Loan restructuring

After job loss or income cuts, lenders may restructure rather than let the loan become a non-performing asset: a lower EMI, a longer tenor, a lower rate, a haircut or an additional loan. Judge it on affordability and on the present value of the new payments.

Example ₹3 lakh over 3 years at 7% (monthly rest): EMI ≈ ₹9,263. Over 5 years: ≈ ₹5,940 (the same present value to the lender, so no real saving, just lower outgo). If the lender takes a haircut to ₹2 lakh over 3 years, the EMI falls to about ₹6,175, a genuine saving in present value terms. A rate cut to 5% (same 3 years) lowers the EMI to about ₹8,991 (the workbook's figure of ₹5,994 appears to mix in a longer tenor); a rate cut is a real saving only if the tenor is not extended.

Fewer instalments save only if each instalment does not rise enough to offset it; any new loan must also be checked on present value.

Remember

• Compare restructuring options on present value, not just EMI.

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11Repayment schedules with varying rates

Each EMI splits into principal and interest: Excel's PPMT gives the principal part and IPMT the interest part for a given period.

Example ₹10 lakh for 10 years at 7%: EMI ≈ ₹11,611; first EMI ≈ ₹5,777 principal and ₹5,833 interest. At 5%: EMI ≈ ₹10,607, with ≈ ₹6,440 principal and ₹4,167 interest in the first month. At 9%: EMI ≈ ₹12,668, with only ≈ ₹5,168 principal and ₹7,500 interest.

Higher rates mean more of each payment goes to interest from the start.

Remember

• PPMT = principal part; IPMT = interest part.

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12Evaluating loans; EMI or tenure when rates change

Criteria: a) interest rate and its method: prefer reducing balance over flat rates on the original principal; b) reset period: long resets delay the benefit of rate cuts (but also delay rate rises); c) processing and legal fees, sometimes waived; d) tenor offered: longer cuts the EMI but raises total interest; e) benchmark: external benchmarks such as the repo rate are transparent and transmit changes faster (both ways); internal benchmarks move slowly. Banks now mostly offer floating loans.

When a floating rate changes, borrowers can change the EMI or the tenure. Keeping the EMI fixed and changing the tenure is usually easier, since the EMI was set to be affordable and rising EMIs can cause distress. But after large rate falls, a one-time EMI reduction can ease monthly outgo; and when EMI pressure is high, adjust the EMI.

Remember

• Reducing-balance rates and external benchmarks are more transparent.

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13Invest or prepay?

With a lump sum, consider:

1. High debt burden: prepaying brings peace of mind, even if not the best use mathematically.
2. Size of the sum: a large sum relative to the loan can make you debt-free early; a small sum barely dents a big loan.
3. Mathematics: compare the loan rate with the expected return. Always repay high-cost credit card or personal loan debt. Over long periods, compounding can make investing better: the invested sum can grow enough to repay the loan and leave a surplus.
4. Risk: if equity might return about 12% against a 7% loan, investing may win, but equity carries risk; even with similar rates, compounding can tilt towards investing if it is sustained.

Remember

• Repay costly debt; invest when expected returns comfortably beat the loan rate.

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14Strategies to clear debt faster

Example Credit card ₹30,000 at 42%, personal loan ₹1.2 lakh at 21%, car loan ₹1 lakh at 12%, home loan ₹15 lakh at 8%.

• Avalanche: pay the highest interest rate first (card → personal loan → car → home). Logical and cheapest, but if the high-rate debts are small, interest pressure may not fall as much as hoped.
• Snowball: pay the smallest balance first, ignoring rates, then roll each freed-up payment into the next. Motivational, but may leave costly debt outstanding longer.
• Blizzard: start with snowball (smallest first, for a quick win), then switch to avalanche (highest rate). Here: card (smallest) → personal loan (now highest rate) → car → home.

Remember

• Avalanche: highest rate first. Snowball: smallest balance first. Blizzard: snowball then avalanche.

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