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With the Reserve Bank of India’s (RBI) six-month moratorium on equated monthly instalments (EMIs) ended on 31 August, individuals who have had to endure the covid-19-induced pay cuts, job losses and rising debts are not sure how to repay their existing loans. The moratorium, while temporarily easing the liquidity crisis for individuals, has also left many borrowers with a bigger loan burden. They will now have to repay the accumulated EMIs with interest. Keeping this in view, RBI has allowed banks to restructure loans for borrowers who still find it difficult to service their EMIs due to the continued economic fallout of covid-19 and its impact on their finances.
The important question is: Do you opt for the loan or debt restructuring plan or do you try and pay off the loan from your available resources?
While loan restructuring is a useful and timely financial scheme, it risks putting borrowers into a debt trap, which must be avoided at all costs. I believe that those who can arrange funds from other sources, such as sale of stocks and mutual funds, should not opt for loan restructuring. Instead, they should become atmanirbhar and repay their loans at the earliest. There is both pride and relief in being self-reliant and self-sufficient.
The idea behind loan restructuring is good as it seeks to provide relief to financially stressed borrowers by reducing the EMI amount or getting another moratorium on the principal, at least till the individual’s financial situation improves.
However, loan restructuring comes at a cost. One, a restructured loan is likely to attract a processing fee (a percentage of the loan amount) and a higher rate of interest than the current loan. Two, given that the restructured loan will have a higher repayment period and/or a payment holiday, the overall interest paid during the duration of the loan will also increase. Thus, it is financially prudent to repay regular EMIs on time, out of the resources available at your disposal, than opt for a restructuring facility.
First and foremost, “borrow” from an emergency fund, if you have one, or a corpus that you might have built for a rainy day. Second, compare the interest rate on your loan against the returns you are making on your various securities and assets like fixed deposits, bonds, shares and mutual funds. It would make more sense to liquidate an asset or investment and repay or reduce your loan if the interest rate on the loan is higher. Third, cut back on your investments in stocks and mutual funds, and redirect those funds towards repaying your loan. The interest cost you save on the loan repayment is likely to be higher than the return on investment, currently.
Though you may want to pay your debts as soon as possible, it’s important to prioritize emergency savings even a small amount that you can use in case an unexpected expense arises. A sudden ER visit or a spouse losing their job can throw a significant wrench into your financial plan. Without designated savings to pull from during such a crisis, you may feel the need to rely on high-interest credit cards or personal loans to cover sudden costs. However, doing so will only compound your debt and make the overall problem worse.
It’s generally a good idea to have six months’ worth of expenses saved in an emergency fund, but this may not be realistic if you are also dealing with debt or otherwise struggling financially. If you’re having difficulty saving at the recommended level, aim to save three months’ worth of expenses instead. Having at least some money set aside for emergencies is better than nothing, and you can always focus on building savings again once you’ve lowered your debt.
As you begin putting away money for an emergency fund, open a high-interest savings account so your money can grow when you pivot to focus on paying down your debt. While you continue to build your emergency fund, it’s also important to make at least the minimum payments on your debts to prevent late fees and potential damage to your credit scores.
It’s important to note that your individual debt repayment strategy will vary based on what type of debt you have. If you primarily have student loans, for example, you may be able to look into deferment, forbearance or loan forgiveness through your loan provider. If you are mostly dealing with credit card debt, these solutions will not be available.
Regardless of what kind of debt you owe, there are two common strategies for repayment: the snowball method and the avalanche method. Both will ultimately help you reach debt-free living but in slightly different ways.
The snowball method consists of listing your debts by total amount and paying off the smallest ones first, slowly working your way up to the most expensive. This strategy is more focused on the psychological benefits of paying off debt. Many people find that the satisfaction you feel when paying small amounts first is highly motivational and helps lessen the emotional burden of debt.
With the avalanche method, you rank your loans based on interest rates, rather than by the total dollar amount. Then you focus on paying off the balances with the highest interest rates first, while continuing to pay the minimum each month on all other loans. This can be particularly helpful if you have credit card debt in addition to student loans or other types of loans, as interest rates are typically higher on credit card accounts.
Whichever strategy you choose, try to make payments beyond the minimum each month. One simple trick is to earmark any unexpected money maybe a bonus or a birthday gift from a family member for debt payments. This also works when you spend less on groceries than you anticipated or otherwise have extra money in your monthly budget.
The problem for many Americans is that their debts are so significant compared to their monthly income that it will take many years to pay the balance down to zero. While it might be tempting to simply postpone saving while you’re paying off debts, that often isn’t a realistic option. Even families with high debt want to be able to purchase a home, have a child, pay for college or provide support for ailing loved ones and that requires substantial savings.
The key, then, is to find the balance that works for you and your family, agree on a plan and stick with it. Our recommendation is to prioritize paying down significant debt while making small contributions to your savings. Once you’ve paid off your debt, you can then more aggressively build your savings by contributing the full amount you were previously paying each month toward debt.
In conclusion, it is always advisable to first take stock of your assets and investments, and see if you can use those to offset your existing loan, instead of going for loan restructuring that could only increase your debt. Repaying on time will also keep your credit profile intact and enable you to take a fresh loan in future.