Juggling your finances between a car loan, home loan, education loan and credit card debt?
No one needs tell you that you are in a living hell.
Being in debt is bad enough. Not managing it well is worse.
The first principle towards settling your debt and moving towards a debt-free existence (however distant it may sound) is in prioritising your debt.
What you must hold on to and what you must clear as soon as possible is the first step towards debt management.
In this article, we will tell you how you can reach that blissful state. Start by asking (and answering) these four questions.
1. Are you getting any tax benefits on the loan?
A home loan and an education loan come with tax benefits.
Under Section 80C, the principal repayment you make on your home loan is eligible for income deduction. The principal is the actual amount you borrow from the home loan company; it does not include the interest payments.
Let's say your taxable income is Rs 1,00,000 and you repaid the home loan principal of Rs 40,000. Your taxable income drops to Rs 60,000 (Rs 1,00,000 - Rs 40,000).
The limit under Section 80 C is Rs 1,00,000.
Under Section 24, the maximum amount of interest that can be deducted from your income is Rs 1,50,000. As a result, your taxable income decreases by that amount.
Let me explain with an example.
Salary income: Rs 3,50,000
Interest payment on home loan: Rs 1,60,000
Taxable income = Rs 3,50,000 (income) - Rs 1,50,000 (maximum limit for interest on home loan) = Rs 2,00,000
If you take an education loan, you can claim a deduction under Section 80E of the Income Tax Act.
Any amount of interest paid by you will be deducted from your income, thus reducing the tax you have to pay.
But the principal amount is no longer eligible for deduction. Only the interest can be deducted. The good news is there is no limit to this amount.
It makes sense to hold on to such loans simply because you get a tax break as you repay them.
Logically, the one with the highest rate of interest is the one that should be cleared quickly.
Two types of loans that should be cleared as soon as possible are personal loans and credit card loans.
The interest rate on these loans is the highest. On credit cards, it amounts to around 24% per annum (at 2% per month). A personal loan should be around 18% onwards.
Even if you get the personal loan at a discount, it would be around 14% per annum.
Interest-free or low interest rate loans from friends and family are the ones you can hold on to, if it will not cause a rift in your relationship.
3. Which are the loans that you can close?
This one will be tough because you have taken a loan to own something.
Sure, you may lose face. But no one is going to come and bail you out. It is better for you to make some smart moves on your own.
Let's say you took a loan to buy a swank car and now realise that you have bitten more than you can chew. In that case, sell the car and close the loan.
You can always buy a car later once you have settled all your debt.
If you have taken a home loan for a huge home and now just don't have the money to pay it off, you can sell the home if you are willing to make some adjustments.
For instance, if you have bought the home in the city limits, you can sell it and move towards the suburbs. If this is the second home you are purchasing, then you can sell it and buy one when you are more financially stable. Or, if you have bought a three-bedroom apartment, you can sell it and opt for a lesser loan and a smaller house, say with two bedrooms.
If you are selling a home on which you have a loan, take a letter from the home finance company or bank asking for the total balance principal payment.
You can ask the buyer of your apartment to make a cheque directly to your bank of that amount. The balance can be given to you. In most cases, you will have to pay the bank a pre-payment fee.
If the buyer too is taking a loan, he can direct his bank or home loan company to make the payment directly.
4. Can you switch the loan?
If the rate of interest on your loan is high, you can switch it to a financier who will charge you a lower rate of interest.
Credit cards do this and call it a balance transfer. Say you are paying 2% or 2.25% per month on your card. You can go in for another credit card. They will pay back the bank and transfer your loan onto the new card. For the first six months, they will give you a lower interest rate. Say 1.5% or 1.75% per month.
This lower rate of interest will help you pay back more.
You can even do so for home loans. But you will have to pay a pre-payment fee. But the new home loan company will pick up the outstanding balance amount and this fee.
Making the right choice
-
The loans that should be cleared as soon as possible are:
1. Loans with the highest interest rate
2. Loans with no tax benefit
Personal loans and credit cards loans fall into this category. They charge the highest interest rate and offer no tax benefits.
If you have taken a loan against your home, then this one too should be a priority. Because if you do not pay the loan, the bank can legally take hold of your home.
- The loans which can be serviced over time:
1. Loans with low/ no interest rate
2. Loans with tax benefits
Home loans and education loan offer tax benefits and can be settled over time. Ditto for loans to family or friends, which are either interest-free or carry a low rate of interest.
- The loans which you can close:
These are loans which are asset backed. For instance, you take a car loan for an asset - which is the car. In such a case, you can sell the car and close the loan.
If you are really struggling to pay your home loan, then you can shift to a smaller home or a home in a location which costs less.
If you are in your twenties, you can even do away with the idea of owning a home till a few years down the road.
Use this only as a last resort since interest rates on home loans are much less than those on the other loans and you still get tax benefits.
Illustration: Dominic Xavier
