Dos and don’ts to prevent your loan turning into bad debt

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November 25, 2020 10:23 AM

A loan is truly effective in meeting your life goals or rescuing you out of a difficult situation only when it is repaid in full on time.

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Many factors can turn your borrowings into bad debt. The borrowed fund can help you in realising your financial goals, support creation of wealth, and bail you out of an emergency. However, if you don’t repay your debts on time, it can also increase your financial burden and put a roadblock in your journey to achieve your financial goals. Such a borrowing often turns into bad debt that could have damaging implications for your finances.

Factors like your repayment capacity, the timing of your loan, the cost of your borrowing and the terms and conditions of your loan could play a significant role in helping you to avoid the creation of bad debt. Let’s dig a bit deeper on this.

Do: Negotiate for a lower loan interest rate and minimal charges

Before you apply for a loan, it’s crucial to compare the various loan offers in the market based on your eligibility. For big-ticket loans like a home loan, education loan or car loan, even a little variation in the interest rate could make a huge difference. Apart from the interest rate, most lenders also charge processing fees, documentation fees, etc. depending on the nature of the loan, which could also increase your loan burden. As such, before taking a loan, always negotiate with your lender to reduce the interest rate and the associated charges. Doing so could save you a significant amount and also ease your EMI burden.

Do: Repay timely

You may be having several critical financial obligations at the same time. However, you must prioritise debt repayment over all other obligations during non-emergency periods. Mismanaging high-interest debt like credit card dues and personal loan EMIs may cost you heavily due to the compounding effect. Your dues could snowball in no time even if you miss only a few instalments making it increasingly difficult for you to clear your dues. Hence, financial discipline in debt repayments can help you in a big way to avoid bad debt, irrespective of the nature of the loan.

Do: Keep CUR below 30%

Your credit card provider might gradually increase the credit limit on your credit card considering your repayment history and income growth. However, a high credit limit on your credit card isn’t a licence to spend recklessly. In fact, you should always aim to keep your total credit card spends or credit utilisation ratio (CUR) below 30% of your total credit limit. For example, if you own one credit card whose credit limit is Rs. 1 lakh, you should try to keep your monthly dues lower than Rs. 30,000. A high CUR could not just make it challenging for you to clear your dues in full on time but could also negatively impact your credit score. Most importantly, doing so would minimise the chances of you defaulting on your card dues and create bad debt.

Don’t: Borrow without reading the fine-print

Lenders often mention the key details in the fine-print of the loan agreement. Not reading the fine-print could turn out to be a costly mistake for the borrower. Things like prepayment charges, penalties, terms about rate revisions, and many other crucial points are mentioned in the loan agreement. So, don’t rush while taking a loan and read the fine-print carefully before signing the agreement with your lender.

Don’t: Borrow more than what you can afford to repay

It’s not uncommon for people to apply for a loan amount that is much bigger than their actual requirement. Later, when they realise they cannot afford to pay it back, they default. As such, always ensure you can repay your loan in time. You can do so by keeping the loan amount under control so that you’re able to pay for the EMIs apart from other critical financial commitments. You should also work towards building an adequate emergency fund that can take care of at least six EMIs in case there’s an unanticipated loss of income.

Don’t: Take a new loan when you already have a big debt

Big debts require bigger planning and greater repayment discipline. If you’re currently servicing a long-term big-ticket loan, you should be very careful before rushing to take a new loan just because you’re eligible for it. You should first ascertain how the new loan EMIs would impact your existing repayment obligations as well as other critical financial commitments. Ideally, your total debt obligations in a month should not be more than 40% of your monthly household income.

Now, if you’re considering signing up for a new loan over and above your existing loan because your income has increased, you should first try to find what could be more beneficial: taking a new loan or closing or pre-closing your existing loan? Having one big loan which you can repay comfortably is usually better than having multiple small loans which you may find it difficult to keep track of and repay.

In conclusion, a loan is truly effective in meeting your life goals or rescuing you out of a difficult situation only when it is repaid in full on time. I hope these tips would help you inculcate the required financial discipline to avoid turning your loan into a bad debt that could put your financial health at great risk.

(The writer is CEO, BankBazaar.com)

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