Don't dodge lender if default is imminent; request for loan recast instead

Also explore options such as swapping higher-cost debt with lower-cost alternatives, and debt consolidation

The recently published Financial Stability Report of 2023 reveals that retail loans have grown at a compounded annual growth rate (CAGR) of 24.8 per cent between March 2021 and March 2023. Over the same timeframe, the share of unsecured retail loans (expressed as a percentage of total retail loans) rose from 22.9 per cent to 25.2 per cent. May 2023 saw credit card spends reach a new high of about Rs 1.4 trillion.

Media reports suggest that the Reserve Bank of India (RBI) may increase risk weights on unsecured loans, which include personal loans and credit cards, to tamp down their rapid growth. In these times of high inflation, elevated borrowing costs, and job losses in certain sectors, borrowers should tread cautiously when availing unsecured loans. And they should act swiftly when they find themselves sliding into a debt trap.

Keep borrowing under control

An individual’s total EMI on various loans should not exceed 40 per cent of net take-home salary. “Assuming around 30 per cent of your salary is allocated towards home and car loan EMIs, you retain a buffer of a further 10 percentage points for repaying unsecured debt, such as credit card outstandings or personal loan EMIs,” says Arnav Pandya, founder, Moneyeduschool.

Act before you default

If you are on the verge of defaulting on a loan, communicate with your lender and apprise it of your predicament. “The natural impulse is to run away from the lender. That should be avoided,” says Arun Ramamurthy, director, digital transformation, branding & strategy, Andromeda Loans.

By evading the lender, one risks falling further into debt. Says Adhil Shetty, chief executive officer (CEO), Bankbazaar: “The vicious cycle of missed payments, late fees, penal interest rates, etc., will cause your loan amount to snowball further.”

Let’s now discuss a few strategies that can help a borrower extricate himself from a debt trap.

Address costliest debt first  

Start by ranking your debts in decreasing order of interest rate, and focus on repaying the most expensive loan first.

Consider reducing your EMI next. “Liquidating assets like gold, shares etc., to repay borrowings is a viable way to achieve this,” says Ramamurthy.

Go for loan restructuring  

Borrowers should also consider restructuring their loans, which essentially means requesting the lender to lengthen the tenure and reduce the EMI.

Borrowers should also try to swap higher-cost loans, such as credit card debt (interest rate between 36 and 42 per cent), with a personal loan that might be available for an interest rate between 10 and 20 per cent. “A top-up on an existing home loan can also be utilised to reduce the burden of unsecured debt,” says Shetty.

Consolidate your debt  

Debt consolidation refers to the conversion of multiple smaller loans into one large loan. “Securing this larger loan might require you to put up collateral, but the interest rate is likely to be lower and the tenure could be longer, both of which would lead to a lower EMI,” says Ramamurthy.

However, bear in mind that a debt consolidation loan usually comes with a few restrictions. “The loan can only be utilised to repay existing loans, all of which must be settled within a specific timeframe. Further borrowing is also not permitted, even in emergencies,” warns Shetty.

Mend your credit score

Those struggling to extricate themselves from a debt trap should consider seeking professional help. Once free from this trap, the focus should shift towards improving one’s credit score. “Building a good repayment track record is the key to this,” says Pandya.

Maintain a contingency fund equivalent to six to nine months of household expenditure. “This ensures you won’t need to borrow even during temporary financial troubles, such as job loss or prolonged illness,” says Ramamurthy.

Debt traps: Symptoms and causes

• Borrowers taking fresh loans to repay current ones is a classic sign of a debt trap
• Persistent pursuit by collection agents is another  
• Regularly running out of cash towards the end of the month, necessitating additional borrowings, is another sign
• Not having a budget; borrowing and spending on impulse, without a concrete plan for how the loan will be repaid can lead to a debt trap
• Forgetting due date for repayment, paying just the minimum amount on credit card debt
• Have too many secured and unsecured loans running concurrently