Managing Debt Add a Value To Your Financial Plan
Written on Monday, September 12, 2016
By Mr. Vishwajeet Parashar
Living one’s life on debt or on EMI’s is fast becoming the way of life. The use of credit card and personal loans to meet day-to-day expenses is gaining strength. The festival season is near. Offers and lucrative offers start flowing from the Independence Day in India. While one earns to spend and live a life full of choices, care should be taken not to overspend. The over-indulgence on shopping is sometimes at the cost of hampering the monthly budget. Over dependence on credit card it seems is becoming a fad all in the name of easy money.
Shop till you drop, but do not shop on credit! Spend on what is essential and not on impulse. An average Indian is perhaps not following all this. No doubt the debt of an average Indian especially of credit card holders is showing an alarming rise. Recent RBI data shows credit card outstanding amount of Rs 42,100 crore at the end of May as against Rs 27,000 crore during the 2008 crisis period. The situation is grimmer because, the interest on credit card outstanding ranges between 36-48 percent a year. Certainly a high price to pay for lifestyle shopping!
In May 2016, total number of credit cards stood at 2.50 crore, up from 1.75 crore in August 2011, but still behind the all time high of 2.67 crore in July 2008. The usage is increasing both for online and offline transactions.
For an investor, paying interest on credit card dues is all the more damaging. Imagine your mutual fund investments earn a return of 12-15 percent for you per annum and the credit card issuer charges you double than that for not paying dues on time. Your investments are not helping you reach your goals properly.
Debt and financial planning
Debt is what we owe (to a person or an institution) and comes at a cost in the form of interest payments in loans. Financial planning is not only about savings but also about organizing your finances. Both investments and debt plays a role in building up a net worth.
Therefore, debt has an important role in the financial planning of an individual. If an investor manages to generate a return of say 12 percent an annum from one’s investment portfolio but pays a similar percentage as interest towards a loan, the net effect is not helping him to create wealth. The first thing investors need to do is to get rid of any debt, which eventually eats into one’s returns. Loans such as personal loans, credit card, home loans, car loans etc are forms of debt.
Living a life on EMI’s to fund car purchases, home buying, and eating out and on other lifestyle expenses needs control and proper management. As a thumb rule, do not exceed EMI’s amount to more than 50 per cent of one’s monthly take-home pay. Home loan lenders therefore take into account to arrive at the amount of loan that can be sanctioned and typically lend such that EMI remains around 45 percent of monthly income.
Perils of debt
Credit card and personal loan are unsecured loans and therefore carry a high interest rate than other kind of debt. The interest rate on personal loan is currently in the range of 13-18 percent or even higher in some cases. The interest rate one pays on credit card outstanding balance (after rolling-over) is in the range of 36- 48 percent per annum. Such unsecured loan especially credit card spending if not managed well can therefore be financially damaging.
Credit card debt is un-constructive debt and can wreak havoc with your finances. If you have large outstanding on the card, stop making any fresh purchases on it. Prepare a plan to get rid of the dues over 1-3 months or as early as possible.
Here are 12 credit card cardinal points to keep in mind while using them:
Do not roll over credit card dues : It’s mandatory to pay only 5 per cent of the due amount each month. This is precisely you should not resort to. Instead, try making full payment on the due date. Rolling over the outstanding balance to the next billing cycle will incur interest rate of 3-4 percent on monthly basis. If you keep rolling over and simultaneously make new purchases each month, the interest portion may balloon and soon one would fall in a debt trap.
Interest-free period may not be there always : Typically, there is an interest-free period on purchases made on credit card. It can be as low as 18 days and can even go up to 45 plus days. To avail this benefit, the outstanding amount has to be nil. So, if you roll over certain amount to next month’s billing, there’s no interest-free period on the new purchases.
Limited usage :There are many who own more than one credit card and few are known to carry as much as 12 of them. Try to not utilize more than 50 per cent of your total credit card limit. One may also put such limit as a mobile or email alert, so that purchases can be monitored. Remember, credit card records and history is shared by banks with the credit bureaus in the country. Higher usage of credit or untimely payments may impact the credit score negatively. Use only a small portion of the total credit limit provided to you as it suggests that you are financially secure and are not reliant on borrowings. So avoid reaching the maximum credit limit on your credit card. There is no thumb rule, but most financial experts believe that it is safe to use up to 50 per cent of the sanctioned limit on your credit card.
Avoid cash withdrawals: Cash withdrawal on the credit card does not come with any interest-free period. There could be a one-time fee plus the interest charges that starts from day one till you repay the amount.
Real worth of Reward points: Earning reward points have become a fad in the credit card industry. Depending on the card variant (entry- -mid-upper level), a card holder may earn certain points on every purchase. For example, there could be 1 point for every Rs 100 spent on the card. Higher spends could make you qualify for more earnings of say 2 or 4 points. The value of the gift that 1 point could fetch could range.25-.50 paisa. Few co-branded cards allow purchasing of petrol against the points or settling them against the bill amount. Opt for these two rather than buying gifts. Overspending for the sake of earning reward points on the card should never be the objective.
Auto debit from your account: Give standing instructions to your banker to deduct full amount each month so that you don’t roll-over the credit to next month. There is another option to pay only 5 percent but its better to pay off the outstanding dues in full.
Convert to EMI’s: If paying entire amount is looking difficult, ask the credit card issuer to convert it into EMI’s which generally comes to lower interest rate then what one pays on normal credit card dues. After conversion (there could be one percent processing fee), the interest hit could be about 18-24 percent lower than the hit on card.
Make a balance transfer: Alternatively, you may transfer the outstanding amount to another credit card at a reduced interest rate. It’s possible only if you hold more than one card.
Watchful eye: Keep a close eye on the credit card statement for any technical errors to avoid paying interest on them. Any late payment will result in late payment fees plus interest charges. Keep the customer copy of the purchase unless bills reflect them properly.
Spending pattern: Importantly, review your card statement to see the pattern of expenses and the areas where it can be brought down. Making a cut on one’s food and outings may help you keep not only interest under control but also one’s household budget.
Overspending: With the credit card in one’s wallet, the world is a marketplace. In case of impulsive buying, try postponing the purchase by 3-5 days. It helps in making the right buying decision.
International usage: Using a credit card abroad could be costly. Use it unless hard pressed for funds. There could be several different charges involved in an international transaction. There could be currency conversion fees of 2-3 per cent on international shopping. Also, if your card is not an International card, you might be charged a fee of 2-3 per cent on each purchase. And, if you use your credit card to withdraw cash while you are travelling abroad, you may have to pay a cash withdrawal fee of around 2-3 per cent of the amount you withdraw.
Do not avoid debt but use it judiciously. After all, one’s usage of debt plays an important role in shaping one’s credit history for any future requirement of loan. Overspending and untimely payments should always be avoided to lead a debt-free life. Over-dependence on credit card to meet day-to-day expenses may lead to a debt-trap and if not properly managed, the damage can soon become irreversible. So, the next time you reach out to your wallet to take that credit card out to swipe, think again.