What should be your first step before you get down to creating your financial plan? Some may say defining your goals and some may talk about planning your investments. But financial planning actually begins with managing your loans or your debt. Managing your loans is not just about reducing your debt but about managing your debt. You need to prioritize your goals in such a way that your debt is taken care of properly. Let us understand the steps of financial planning and debt management and the role of containing the level of loan financing in financial management. Let us also understand debt management from the prioritization point of view. Here is how to go about it and also why it is important.
1. First get rid of high cost debt
They are the actual drag on your finances. When you are running your credit on revolving credit by paying just 5% of the outstanding, then you are paying a huge cost of 3% per month. That adds up to nearly 38% on an annual basis. If you pay 38% interest on loans then there is no way that you are going to ever generate wealth on your portfolio. Whatever you earn will only be sufficient to pay your debt. Whatever surplus you have or whatever you can generate from capital gains, use to pay off debt classes like credit cards or personal loans.
2. Regarding the other loans, try to negotiate your way through
Quite often there are other loans like car loans, gold loans and home loans. What to do with these loans. Obviously you want to hold on to home loans as the tax benefits are quite valuable to you. What about your car loans? Car loans typically have negative equity because the value of the car comes down by at least 30% the moment it is driven out of the showroom. That means at any point of time the value of the loan is always higher than the market value of the car. If you get an opportunity to close the car loan, you can bargain with the bank for zero prepayment charges and close the loan.
3. What about home loans where tax shields are diminishing?
Home loans offer you two kinds of tax shields. There is a tax exemption up to Rs.2 lakh on the interest component and then there is also an exemption under Section 80C on the principal component. Normally, the interest component on the home loan is higher in the initial years and then starts falling in later years. At that point if you get surplus cash with you, it can be seen as an opportunity to close your home loan. There is no point in continuing your home loan when the incremental tax benefits are limited and you can use the EMI component to make a more worthwhile investment. Alternatively, if you find that that the apartment is giving you negative equity then it is always better to close out the loan as you don’t run the risk. Once you have closed the home loan you can look at what is to be done with the property.
4. You can also look to restructure your loans on more favourable terms
A good credit score and a good relationship with the bank can be quite valuable in a variety of ways. For example, if you are having too many small loans, you can approach your bank to consolidate these loans into a single loan to make servicing easier. Alternatively, you can also look to extend the tenure of the loan to reduce the EMI and put lower pressure on your finances. These don’t have any standard model but you can sit across the table and negotiate with the bank.
Why is loan management so important? Firstly, loans are commitments and if the commitments are high cost commitments then we run a major financial risk. Secondly, some loans backed by assets do come at a lower cost but they put your assets at risk. Look at an opportunity to reduce such loans and reduce the risk to your assets. A proper loan management strategy lies at the core of a healthy financial plan.