How to get out of a debt trap

There are options like loan against property, stocks and life insurance policies.

Mounting debt has become a problem for many. It just takes a few credit card bills, a personal loan, an auto loan and a home loan to make things bad.

Ideally, your total installment-to-income ratio should not be more that 40-50 per cent, but many exceed this limit. Result: They keep on borrowing to retire earlier loans – a classic debt trap.

When overleveraged, it is best to start looking to clean up one’s act. This will ensure that the huge debt isn’t a drain on your take-home salary. Also, lessening the debt will substantially increase your ability to raise more funds.

Start by targeting the most expensive loan. Mukesh Dedhia, director, Ghalla Bhansali Stock Brokers, said, “By this parameter, credit card loans should be cleared first.” In case of credit card loans, one can end up paying as much as 40-50 per cent interest every year. Then come personal loans. Existing rates for personal loans are 14-30 per cent. The interest rates for credit card and personal loans are high as there is no collateral.

Car loans are also expensive but have the cushion of a collateral. One can sell the car if one is desperate for cash. Also, taking a car loan makes sense for businessmen as it gives them the chance to claim depreciation. D Sundararajan, CEO, Trendy Investments, said, “The interest payment for an auto loan is deductible from business income. However, this does not apply to salaried individuals.”

Home loans, which are generally the biggest in terms of the amount, need not be paid off as fast as other loans because they provide tax benefits — interest payments up to Rs 1.5 lakh are deducted from taxable income while calculating the tax liability. Also, principal payment of up to Rs 1 lakh is eligible for tax benefits under Section 80C.

Now that the order of repayment has been identified, here’s how one can go about it.

Suppose you have Rs 2 lakh credit card bills, a Rs 1-lakh personal loan, a Rs 4-lakh car loan and a Rs 35-lakh home loan. How you go about repaying them? There are various options.

One, use low-interest yielding fixed deposits or sell some investments to retire credit card and personal loans. If this is not possible, take a loan against your life insurance policy.

One can even take a bigger personal loan and pay off credit card and personal loans. In this manner, one can consolidate two high-interest loans into one.

Then, there are cheaper options like taking a loan against property. Most big banks allow you to borrow against property. The amount, in this case, is much higher and can allow you retire credit card, personal and auto loans at one go.

The product works like this. If you own a property worth Rs 45 lakh, the bank will be willing to loan you 40-60 per cent of the value of the property. However, if you have an existing loan on this property, the valuation will be done in a different manner.

Suppose that five years ago, you bought a property for Rs 45 lakh by taking a home loan and its present value is Rs 60 lakh. In such a scenario, the bank will loan you 40-50 per cent of the incremental value.

And then, there is the yellow metal. According to Dedhia, if one urgently needs money, one can keep the gold as a collateral with a bank to raise cash. But in India, most people have jewellery rather than gold bars. This reduces the value of the gold by 10-15 per cent.