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How NOT to fall into a debt trap
Joydeep Ghosh in Mumbai | May 07, 2007
When Rajesh Joshi hired Vishal Sinha, he told his business partner that he had hired one hell of a guy. Maybe a tad more expensive than the company's budget (at a princely sum of Rs 50,000 per month) perhaps, but Vishal fitted the job profile just perfectly.
However, just three months later, Rajesh felt let down. Vishal was promising but not performing. He always looked hassled and worried about something. Finally, Rajesh took him out for lunch and asked, "Is there a problem with the company?" Not yet came the reply. "Are you uncomfortable about something?" After a bit of thought, Vishal responded with a "Yes". And as it mostly is, the problem turned out to be financial.
Simply put, his equated monthly instalment (EMI) plus bill payout was around Rs 38,000. Just slightly less than his take-home salary of Rs 42,000. This included a home loan, an auto loan, and credit card and utility bills. "Since hiking the salary was out of question, I called my chartered accountant and personally sat with Vishal to solve his financial mess," he says. If this story is a familiar one, then it is time you sought some serious help.
When SBI chairman O P Bhatt said last week that defaults on housing loans are on the rise (the bank itself has around 4 per cent), he sent clear signals that the rush to cash in on the booming housing sector is beginning to backfire for the banking sector. Besides, there are also reports of rising defaults on credit cards and personal loans. While the industry could be gearing up to face more defaults, for the individual also, it is time to take a step back and reassess his finances.
Typically, this is how one thinks when looking for loans: How much home loan can I garner; how much more can I get for that car? And banks have not really helped by offering 50 per cent and more of the salary as home loan. "The banks may give you that privilege but it is not necessary for you to exercise it," says Ranjeet Mudholkar, CEO, Financial Planning Standards Board, India. Instead, the criteria should be what one needs and can afford. Of course, many will scoff at this idea because salaries are shooting at a very fast rate. But so is expenditure.
Relying on future incomes to repay present debts is not a very bright idea. Financial experts always advise that your monthly EMIs should not exceed 40-45 per cent of your take-home salary, and that too, if you have a home loan. Otherwise, your EMIs should not exceed more than 10-15 per cent of the take-home salary.
But most of us are unable to maintain that upper limit. As a thumb rule, one gets 3.5 times his gross income as home loan. That is, a person with an annual income of Rs 6 lakh is eligible for a loan of around Rs 17 lakh to Rs 24 lakh. Then, there may be a top-up of 10-15 per cent for furnishing the house. These numbers may not seem much in isolation But added, they turn the monthly outgo into one monstrous number.
For instance, suppose you identify a house worth Rs 22 lakh. You take a loan of Rs 19.8 lakh, that is, 90 per cent of the price. Your EMI at 11.25 per cent rate of interest would be Rs 22,816, or almost 44 per cent of your salary. Add to this a top-up loan of Rs 2 lakh for five years. That adds to the EMI by another Rs 5,587.
So the total EMI will be Rs 28,403. Now this is almost 48 per cent of your salary. And this number keeps on increasing as you add insurance expenses, utility bills, an occasional dinner and even that new pair of shoes. Which means at this rate your investible funds are coming down at a very fast pace. Says D Sundararajan, investment consultant, Trendy Investments, "One needs to do proper cash-flow planning. So the ideal way to buy a car or home is by looking at your current surplus." This is because future incomes are uncertain.
One should look at two ratios - Debt Service Coverage Ratio and the Solvency Ratio - before going for any kind of loan. This will give you a clear idea whether you will be able to afford that house, car or air-conditioner on loan or not. Any amount higher than 50 per cent of your take-home is a clear indication that you could be heading for trouble if the situation changes for the worse. That is, a sudden spurt in interest rates can totally destabilise your finances. And while calculating the solvency ratio, do not count the home you live in or the car you use as assets because they are for self-use and not investments.
Finally, as Sundararajan puts it, "While consumers can be blamed for over-spending and falling in a debt trap, banks should also take care before lending." This is because the credit bureau is still not in full force and thus banks do not have an idea about an individual's earlier loan position.
But since the onus is on you, it would be great if you do not find yourself in a situation where loans exceed your ability to repay. It is best for your heart, as well.