Credit, quite like a strong drug, can be a life saver if taken in appropriate quantity in the hour of need. But increasing its dosage without considering your health, financial health in this case, can have its own inevitable consequences. By the time you realise this, you may already be inside the infamous debt trap, unable to make the necessary payments and bleeding money in interest.
“The rule of thumb for a healthy debt to salary ratio is 40:60, i.e, the moment you start paying EMI higher than 40% of your monthly net salary, you have crossed the prudential norm. Your immediate focus should be on reducing it within the next 2-3 quarters or next appraisal, without any forward commitment. You can take 5-10% liberty in the case of a home loan, if you and your family are staying in this property and thereby saving on income tax as well as rental outgo,” says Satyam Kumar, Co-Founder, Loantap.
Taking all these things into consideration, carefully assess your financial situation and see if it’s showing any of the below signs. If the answer to any of them is yes, you may just be walking into a debt snare.
i. Debt for consumption:
Other than house property, everything else is depreciating asset. The value of things like automobile (car), bike (two wheeler), phone, etc. will decrease over time. So, “technically you will be going through depreciation loss and interest cost (payment) that means we should evaluate purchases from ‘good to have’ and ‘must have’ category. And on good to have items, you should not be spending more than 2-3 months of salary. Practically, you should be able to pay instalments on these products within 8-10 months, without straining your cash flow,” says Kumar.
Of course, the 8 to 10-month rule cannot apply to a car loan or a two wheeler loan. They have to be looked through the 40:60 prism.
ii. Unfeasible lifestyle:
It is very compelling to have a luxurious lifestyle. It may begin with a few indulgences and before you know it, living out of your means may become a habit. Check if you are shopping, travelling, eating out or partying in ways that go beyond your means. “If the answer to this question is a resounding ‘yes’, then you are doubtlessly going to mar your financial stability in the future. Reconsider the way you spend, evaluate what you can and cannot afford and take stock of how much you are saving before you spend on luxuries,” informs Kumar.
Controlling your desire is very tough when banks and financial institutions are keen to push easy money into your wallet, but do understand it’s a loan, which has to be paid back with interest in the stipulated period.
iii. Credit card limit:
If you’re always on the brink of your credit limit, it’s a danger sign. This means in case of an unforeseen expense, such as maintenance of a broken down vehicle or a medical emergency, you’ll be strapped for finances and may have to take more expensive credit, in addition to the bill you’ve already racked up on your credit card. Be cautious, therefore, to spend only up to 20 percent of your credit card limit.
iv. Not keeping a tab of expenses:
Aren’t you keeping a tab of your expenses? That’s not a good sign. “When you take a loan, it becomes imperative that you take stock of your expenses and gain a greater visibility within your finances. It enables you to match your monthly cash outflows with the incoming salary and make room to absorb additional expenses,” says Kumar.
If your income gets redirected to your outstanding EMIs, it will undoubtedly make it impossible to cope up with your expenses throughout the month. You often end up in this vicious cycle if the EMI tends to be more than 40 percent of the income.
vi. Not considering loan terms:
You planned to take a loan that had a very attractive interest rate. But what you failed to notice was that the loan product’s interest was variable rather than fixed. As the prevalent interest rate soared, so did your monthly instalment, creating undue pressure on your already-stressed monthly budget!
vii. Not getting additional loans:
If your loan application is getting rejected by lenders, it means you’re already overburdened by liabilities and have weak cash flows. “There’s a strong possibility that you’ve slipped into the debt trap already. Don’t be dejected by the rejections. Instead, fix your current situation quickly and pay off as much outstanding debt as you can before taking on more loans,” says Kumar.