With so many relying on and eventually getting drowned in the whirlpool of Debt, here is an understanding on its mechanics to help keep afloat at all times
Debt, as we know, is the amount of monies borrowed by one party from another.
Debt as a term is also an acronym –
- D – Debt
- E – Earnest (Debt is availed with the sincere intention to repay)
- B – Burden
- T – Time (to be repaid within a specified period)
If this earnest (trust) is breached as a result of default in repayment of existing debt, the chances of availing new debt often reduce drastically.
The following summarizes the basics of DEBT:
WHY DEBT / PURPOSE OF LOAN
Individual: For recurring expenses / one-time expenses / for purchase of asset / (refinance existing debt)
Corporates: For business operations / for purchase of asset / (refinance existing debt)
Government: For Government expenses / for Development / (refinance existing debt)
TYPE OF LOAN
Individual: Personal Loan
Corporates: Business Loan
Government: Sovereign Loan
Individual: Employer / Banks / Financial institutions / Individuals
Corporates: Banks / Financial Institutions and Markets
Government: Banks / Financial Institutions / Markets
COST OF DEBT
Individual: Interest and processing fees or one-time charges
Corporates: Interest and processing fees or one-time charges
Government: Interest and processing fees or one-time charges
Individual: Few weeks / Few months / Few years
Corporates: Few months / Few years
Government: Longer term generally
SOURCES OF REPAYMENT
Individual: Salary Income, interest income / income from investments, business income or Fresh Debt (refinance existing debt)
Corporates: Business Profits or Fresh Debt (refinance existing debt)
Government: Earnings from taxes and other revenues or Fresh Debt (refinance existing debt)
While many of the developed and developing economies of the world are heavily indebted in terms of their borrowing vs their country’s Gross Domestic Product, we will focus on Personal Debt in this article, leaving the Sovereign Countries and the Business Houses to manage their debt obligation effectively.
The Golden Rule of Debt
In business, we always maintain a stance – Debt should only be availed only if there is more certainty of future profits, meaning, DEBT SHOULD BE REPAID OUT OF PROFITS. Similarly, at a personal level too, individuals should exercise caution and follow a thumb rule before they sign up for debt, be it from a friend or their employer / bank / developer / any other lender.
The question then comes to one’s mind, what is the level of debt that an individual can sustain? Here’s a thumb rule that may be tweaked carefully –
Annual take-home pay / income: Maximum 20 % of this amount can be considered for debt repayment (including repayment of the principal amount plus interest)
Monthly take-home pay / income: Maximum 10 % of this amount can be considered for debt repayment (including repayment of the principal amount plus interest)
This THUMB RULE will assist the individual in maintaining a financial discipline that improves financial health, thereby improving CREDIT SCORE and enhancing the E factor in dEbt, ie. Earnest or Trust.
Sustainability of Debt: Maths Vs Myth
Maths and Myth are two sides of Debt, two separate thought processes on each side of the ‘What IF’ wall.
The sky will not always be clear and there will be times when clouds spread across the sky, followed by rain. It is this time that the borrowers need to be prepared for this rainy day in any given situation. Remember to stay on the right side of the chart image, the SAFE ZONE.
It is easier to approach a friend, employer, or bank at an individual level and seek a loan, be it on a credit card, cash withdrawal, or finance asset purchase / school fees / expenses. However, such borrowing (debt) needs to be sustainable, backed by a source of income. Unless the THUMB RULE (even if tweaked) is followed, Individuals opt for excessive debt at times and fail to honor their repayment obligations, living in the myth that they will be able to avert from default, which may result in duress later.
Lenders will not wait for recovery of the outstanding loan amount, and the least that an individual may expect is to default in servicing debt that may result in further consequences.
A Word of Caution: No one who lived through and is alive today can ever forget the year 2020 and the impact caused across the globe. The Central Banks across slashed interest rates, which was a sigh of relief for borrowers. Two years ahead, in 2022, we are already seeing signs that Central Banks may raise interest rates, which may lead to a rise in interest rates for loans as well. The increase in interest rates will lead to a higher obligation in terms of repayment of loans (considering additional interest) that the individuals should plan for.
The Remedy: Examine Your Financial Health Regularly
The three aspects of health are Physical Health, Mental Health, and the ignored side – Financial Health.
Every individual is responsible for their own obligation. For a safe and sustainable living, monitoring Financial Health is equally important as is Physical and Mental Health.
At periodic intervals, every individual needs to analyze a few numbers in terms of,
- Fixed monthly income
- Accumulated cash savings
- Investments that can be accessed at any given time (liquidity)
- Assets owned, and
- Fund requirements to honor obligations, be it monthly, quarterly, or yearly
Always prepare for a rainy day and place a certain amount of funds aside for CONTINGENCIES. This contingency fund will always help individuals and their families in need of the hour.
“If We Fail to Plan, We Plan to Fail”
Simple as it may sound, it is a healthy practice to ensure that any debt obligation, at any level, should be sustainable for a healthier financial world for us and the generation in progress.
Wishing you the best of Physical, Mental, and Financial Health always.
Dhaval can be reached at [email protected]