When available funds are insufficient then we can use debt to finance goals. we earn more than spends. our income is still not enough to fund or buy assets using existing savings.
Mortgage
Most people cannot buy a house without loan. This is because cost of a house is huge. if people waited till they had enough savings to buy a house then it is likely that this would not be possible till they near retirement. Lenders protect themselves by securing their loan against a charge or security or pledge or mortgage on the property. Such loans are also called mortgages.
Other debt includes auto loan, credits taken for buying consumers durables, personal loans and credit card outstanding. However debt comes at a cost and imposes a repayment obligation on the borrower. The decision on whether or not to use debt will depend upon the ability of the available income to bear the additional charge of interest cost and repayment.
Leverage
Debt is not always bad. in some cases the decision to use borrowed funds over own funds, also called leverage. It may actually increase the return made on investment. In some cases a loan may make more sense in a given situation. For example education loans is better choice than drawing from a retirement account to fund the children’s education. The future income would be easily able to repay the loan. t the same time the existing funds can continue to earn without losing the benefits of compounding.
Sometimes we need debt under various circumstances for example like temporary use of funds. This kind of short term needs might arise due to some emergency or some cash flow mismanagement. But it can ensure that an individual is able to continue on their lifepath without facing sudden disruptions
Role and impact of debt in cash flow management
While some debt is good. Some may even get recommendations. how much debt is good depends upon the financial situation of each household.
Debt to income ratio
A good indicator is the debt to income ratio(DTI). It meansure tha ability to meet the obligations arising from debt with the available income. There is no perfect or optimal DTI ratio that lenders require, but all lenders tend to agree that a lower DTI is better. Depending on the size and type of loan they’re using, lenders set their own limits on how low your DTI must be for loan approval. Consider a salaried employee rajesh who draws a salary of rs 15000 per month and is paying rs 7500 towards debt servicing. Debt servicing ratio comes to 7500÷15000=50%.This is too high if 50% goes toward debt servicing it affects the ability to meet other regular expenses, provide for emergencies and the person may have nothing left to invest for the future.
Effect of interest rates on debt
The interest rate and the amount of debt play an important role as far as the measurement of impact of debt is concerned. A higher interest rate will raise the repayment amount. One has to look at the cash flow and then decide on the amount of debt that will be taken. All this needs to be done to ensure that debt and its outflow do not disrupt the entire cash flow mangement plan laid out. Often there could be situation where in debt servicing needs are high and at the same time a crisis on some other front can leave little room for borrowing some more amounts to tide over it. This is the reason why the debt servicing amount needs to be low so that there is scope for raising some more funds in case this is required
Differentiating between consumption expenditure and investment expediture
Many clients have endless list of life style expenses. Investment adviser should be able to influence the client to be prudent in the expenditure. This can be done by highlighting how expenditure might affect the chances of the family being able to fulfil some other financial goal.
One way to differentiate the various expenditure is by classifying them as consumption expenditure and investment expenditure. Consumption Expenditure is that amount which once used does not create any assets that generates further income. Amount spend at a restaurant or for buying clothes or expenses made at saloon are some examples of consumption expenditure. On the other hand investment expenditure will lead to creation of an asset that generates further income in future. The trade offs should be clearly understood by the clients. For example buying a bond or property can be investment expenditure. Some outflows like providing education to children may appear to be consumption expenditure but they may be a useful investment if children do well and are able to raise the family’s income. Such expenditure needs to be prioritized.
A budget that clearly demarcates mandatory and legal payments such as taxes contribution to provident fund and gratuity and loan commitment, essential living expense such as food and shelter and discretionary expenses such as lifestyle expenses, will help allocate income better between current and future needs. Allocate saving for goals before considering any discretionary expenses. This will make sure that future needs are taken care of
Systematic investment plan (SIP) especially when automatically transferred from salary, helps in prioritizing the investment expenditure.
Very often, clients do not realize how much money goes in various avoidable expenses. The adviser should inculcate the habit in client to note down all expenses above a specific level. Llimit may be rs 500 for some client, rs 5000 for some others. The actual figure would depend on income level of client. The summarisation of list of expenses at the end of month can be enlightening even for client. For eg amount that went in eating out or entertainment might be pretty high but this might not register for client because all payment were made by credit card so this was not actually tracked.
When client recognizes the scale of the lost opportunity to save, there is better likelihood of prudence in future. An adviser’s primary role is to identify and eliminate these holes that inhibit savings. There are often cases where a lot of money is spent on buying the latest gadgets when this is not necessary. Spending on gadget like a phone Or laptop is necessary because it helps in work and increase efficiency and learning for an individual or the household. However constant upgradation just so that they have the latest model to show off is not a wise way to spend money and the amount saved from such expenses can be used at several other places.
How to manage the windfall of money?
Client occasionally earn a windfall such as unexpectedly high annual bonuses, inheritance, winning a lottery etc. A healthy portion of such unexpected income should be set apart for the future since the family is used to living without that windfall. This can also be time to take a look at the outstanding loans and consider prepaying some of them.
Windfall gain need not to be invested immediately as appropriate investment opportunities may not be available at the time gain occurs. The gain may be held in risk free liquid assets till the investment decisions is reached. The amount of windfall should be properly allocated as the extent of windfall matters. For eg a very high annual bonus a year can be used to prepay loans and at the same time make some additional investment too, which can yield a return in the future.
One should not expect a windfall to occur regularly in hope that this will save a bad financial situation. As this can encourage wayward financial behavior and still end up with higher amount of debt when the windfall does not materialize. Debt or loan should be ideally taken for acquiring appreciating assets such as real estate. Some debt may be recommended to meet an expense that will increase the value of an asset say an education loan to upskill so that the income generating ability of the person goes up. Financing risky or volatile investment proposition with debt may entail high risk &may put entire financial security of individual of household at risk
Margin financing for stock market investing is one such investment. A fall in the value of the investment will magnify the loss since the cost of debt will also have to be accounted for. Debt should certainly not be used for financing one’s regular expenses. If a person starts borrowing to meet expenses then he is clearly living beyond his means and likely to be in debt trap.
Taking short term debt to tide over temporary liquidity problems may be fine as long as the borrower knows the risk and has a plan to repay the dbet as soon as possible.
Secured loans such as mortgages and education loans are relatively cheaper as there is the benefits of the security available to the lender. Unsecured loans such as personal loans and credit card debt are very expensive and must be used with caution.
Credit card strategies
Credit card is an interest free borrowing option only if the use is within limits specified. And the repayments are made by due date each month. When credit card user does not pay the entire amount ie some amount is carried over for the payment in the following business cycles, it is called revolving credit. If credit card company charges 3℅ pm as interest, the compounded annual cost (1+3%) ^12-1=42.6%.
Given the exorbitant costs revolving credit should be avoided. A similar argument can be made for loans for unorganized sector like pawn traders or money lenders who charge as high as 60-80% interest rate or 5% a month from people.
Shorter the tenor of the loan, more will be periodic repayments putting pressure on available income. Even if cost of debt is low short loan tenor can put financial pressure in repayments. Therefore loan tenor should be decided keeping in mind the repayments capacity of the borrower. A longer tenor loans translates into higher interest paid over the term. The debt to income ratio can be used as an indicator of what the household income can take on as repayments obligation and decide on the tenor accordingly.
Debt mitigation strategy
Rank debt in order of their cost and deal with the costliest debt first. Typically credit card dues and personal loans will be most expensive and work to eliminate them from outstanding debt list.
Low cost debt and debt that provides tax benefits such as home loans and education loans can be dealt with later when finances permit. The debt was taken for purchasing assets then the asset can be sold and the proceeds used for prepaying the debt. While doing this the borrower should also plan for any prepayment charges that bank may levy
If cost of debt is high then cheaper refinancing is an option. A lower cost loan can be availed to repay the costlier loan. A credit card balance transfer is an example of such financing. If the problem is with the tenor of the loan then the possibility of extending the tenor of the loan can be explored. This will reduce monthly outgo in debt servicing.
However the loan will be repaid over the longer period of time and total interest paid over the tenor will go up.
One of the key points that every individual needs to follow is that they should never borrow more than what they can afford. A lifestyle that is flashy might seem enchanting but there is cost that has to be paid for this and if this is not sustainable then it is better to not to go down that path.
Secured loan and unsecured loan
One is secured loans and as the name suggests these loans are backed by some assets as security. Most common example of such a secured loan is that of housing loans. When an individual takes a housing loan the lender takes the house as a security or mortgage. This is a source of comfort for the lender in case the borrower is not able to repay the money.
The assets that is present as security remains in the name of borrower but in case the loan is not repaid then the borrower can take over and dispose off the assets to recover the money. Most visible outcome of such a security is that the interest rates on such loans are relatively lower. Vehicle loans, gold loans , loans against securities are some of example of secured loans.
Unsecured loans are those loans where the lender does not take any security from the borrower. In such loans there is just the personal security or gurantee of borrower to repay the amount so this is more risky in terms of lending. The outcome is that such loans are costlier in terms of higher interest rate to be paid by the borrower. Example of such loans are personal loans and credit card dues. The interest rate on such loans can be quite steep. Client should be advised to use secured loans for building long term assets as Costs will be lower if needed and ensure that the unsecured loans are kept to minimum or regularly paid before the interest cycle kicks in on credit cards.
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