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.
So which financial resources can come to your aid in this situation? 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.
Let’s look at the last with an example. If an individual has an outstanding loan at 18% per annum, then a fresh investment would be justified only if he or she can earn a return of at least 18% per annum on it. Looking at historical returns in the stock markets, mutual funds and in debt instruments, this could be unsustainable in the short- to medium-term.
Based on the interest rates on loans and the returns from various asset classes, I recommend the following steps for a financial reboot. One, pay all your outstanding credit card dues and avoid 30-45% annual interest. Two, retire unsecured loans (these can be at interest rates in the range of 11-30% per annum). Three, repay home loans or loans against property (the majority of them will be at 9-15% per annum). Four, build a corpus that should be at least six months your monthly household expenses and a fixed amount for medical exigency and secure it in a sweep-in fixed deposit.
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.
Gaurav Chopra is co-founder and CEO, IndiaLends