ET Wealth | How borrowers can become debt-free | Economic Times

As the moratorium draws to an end, banks have started their collection efforts. Borrowers who opted for the relief now face an even bigger burden. Banks might restructure loans, but won’t waive the interest dues. They are now more picky about who they lend to. Many borrowers might find that even if their credit score was intact, lenders are not entertaining their loan requests or charging a much higher rate of interest.Those with multiple loans will particularly feel the pinch. If you find yourself in a debt quagmire, you may have to change tack so that you can quickly get out of the debt trap. Circumstances may have hit you, but some bold steps can bring things back on track. Rachit Chawla, Founder and CEO, Finway, says, “The next few months are going to be rough, but good planning can go a long way.” This week’s cover story charts out a path for stressed borrowers to get over the debt overhang amid the stark realities of the Covid-hit environment.Watch your credit scoreBorrowing will be difficult in the Covid-hit world. Getting a personal loan will be particularly hard for those who opted for the moratorium. The RBI had categorically stated that opting for the moratorium will not dilute a borrower’s credit score. But banks are treating the moratorium as evidence of a person’s inability to repay a loan.Some banks have even tightened lending norms. Banks typically charge the lowest rate to their most creditworthy customers. Borrowers lower on the credit score ladder are charged higher rates. The lower your credit score, the higher is the risk premium. Bank of Baroda, for instance, has adopted a stricter lending policy by increasing the credit score requirements for new borrowers, besides increasing the risk premium. Earlier, it charged a risk premium of 25 basis points above its best rate for customers with credit scores of 701-725. Now, the credit score requirement for the same bucket is between 726 and 775. It is also charging a higher risk premium of 35 basis points. Other banks are also becoming cautious. “Over the next 6-9 months, we would see considerable tightening of credit norms. Customers who showed financial prudence and maintained a good repayment history will be sought after while others will find it extremely difficult to obtain credit,” says Abhishek Agarwal, CEO, CreditVidya.In this backdrop, it is critical to watch your credit score. Vivek Rege, CEO, V R Wealth Advisors, says, “Having a bad credit score can have more serious repercussions than you think. A good credit score on the other hand can come to your rescue when you need it the most.” In case you notice a discrepancy in your credit score, get it rectified immediately. Else you may find yourself in the lower bracket that attracts a higher risk premium. If your credit score has deteriorated owing to some minor issues like delay in payment of utility bills, make sure you get it fixed at the earliest. This is not just critical for new borrowers but also for those with existing loans. Adhil Shetty, CEO, BankBazaar, warns, “The bank can revise the risk premium even for existing loans if your credit assessment undergoes a substantial change.”Avoid taking further reliefThe more EMIs you skip, higher will be the interest cost.Assuming loan amount Rs 50 lakh at 8.5% interest for initial 20 years, 12 EMIs already paid before opting for moratorium. 78073645What borrowers should doFor those coming out of the moratorium, the monthly repayment schedule resumes from September. The post-moratorium repayment will obviously be higher than what it used to be, thanks to the unpaid interest accumulated during the moratorium period. As ET Wealth pointed out at the time, this relief was only a deferment and not a waiver, as many perceived. While this has been challenged in the Supreme Court, the central bank maintains its stand that interest will not be waived under moratorium. Planners say that borrowers should not wait for the verdict but start repaying loans immediately. Even if the court provides relief, your repayments will not go waste.Some lenders may give borrowers the option to pay off the accumulated interest in one shot at the end of the moratorium. Experts say those who have the means should ideally use this option. “Your best option would be to pay the accrued interest at the end of the moratorium and continue with your loan as usual,” points out Shetty. Many borrowers opted for the moratorium simply because the option was on the table. Many others got automatic relief under the “opt-out” mechanism although they did not need relief. They didn’t realise that their loans got frozen under this window. Rege says such borrowers must pay off the deferred payments immediately. “If you don’t face a cash crunch, start repaying loans without further delay,” he says.Settling moratorium duesHere are the likely options before borrowers who opted for the moratorium 78073659Many lenders reported a fall in number of borrowers availing the moratorium in its second phase. This is mainly attributed to a shift to the “opt-in” mechanism under the second phase and the gradual unlocking of the economy. “We observe that a majority of borrowers in the affluent and middle-income segments have seen their incomes return to certain normalcy. Such individuals should try to repay the loan without availing further moratorium,” says Agarwal.Though interest may have piled up, certain steps can help get rid of it. Shetty suggests borrowers should aim to prepay up to 120% of the EMIs they deferred within the next 12 months. For example, if they had deferred five EMIs, they should pre-pay six extra EMIs over the next 12 months. This will erase the burden of the additional interest.Pay off deferred EMIs to get back on trackIf within 12 months you pay off 120% of EMI amounts deferred, it will erase the burden of extra interest.Source: BankBazaar 78073664For those genuinely unable to repay, it is likely that your bank will offer a loan recast. The government has asked banks and NBFCs to roll out stressed loan resolution schemes by 15 September. Only those individuals whose loans accounts are in default for not more than 30 days as on 1 March will be eligible for a one-time restructuring. Veena Sivaramakrishnan, Partner, Shardul Amarchand Mangaldas & Co, says, “Providing additional comfort and ensuring that there is seriousness on part of the borrower would be the key factors that a lender would consider.”The loan resolution terms will vary across lenders. Some lenders may extend the repayment tenure to accommodate the additional interest. Others may hike the EMI or offer step-up EMIs, with a lower payout for a couple of years to make up for initial loss of income or salary cut owing to the pandemic.Should you extend the loan term or hike the EMI?Hiking the EMI will work out better than extending the loan tenure after moratorium ends. 78073679If the borrower faces acute difficulty, some banks may even offer an extension of moratorium by a defined period of time. The RBI has clarified that the moratorium is extendable by another two years if deemed necessary. However, we strongly advise against opting for extended relief. If missing only three EMIs can add 11 EMIs to your loan tenure, imagine what will deferring 6-12 months payments will have on the loan. If you can do so, pay your EMIs and avoid restructuring plans. “Further extension of moratorium should only be used by those who are struggling to earn from alternative sources,” advises Agarwal. Most importantly, cut down on taking fresh loans unless these are taken to prepay existing, costlier loans.Which loan should you repay first?If a borrower has three loans, here is how he can prioritise repayments to minimise the financial hit and get rid of debt faster. 78073683Tackle higher cost loans firstThose with multiple loans should prioritise the order of repayment. You may either repay the smallest loans first or target the costliest loans. In the first approach— known as ‘debt snowball’ repayment strategy—as soon as the debt with smallest outstanding balance is paid off, the freed-up outgo is used to pay down the next smallest debt, until all debts are paid off. Clearing the low-ticket size loans may bring immediate mental relief of having paid off loans quickly. But while the number of loans may come down quickly, it won’t be the quickest way to bring down your aggregate debt burden. In fact, it will cost you more.Ideally, loan repayments should prioritised on the basis of costs. The most expensive loan should be tackled first. Once you have cleared the costliest debt, move to the next one. This repayment technique is the ‘debt avalanche’. Directing surplus payment towards clearing the most expensive loan brings down the total interest cost on all loans and may even clear your debt pile quicker. The only caveat here is that you continue paying regular EMIs on the other loans. 78073688If you can’t repay the high cost loan, approach the lender to renegotiate the terms. Interest rates are the lowest in many years and you can benefit from switching to a lower interest rate. This will involve a one-time cost, which is typically around 1-2% of the outstanding loan, capped between Rs 25,000- Rs 50,000 depending on the bank. Another way to pay off high cost loans is to top-up a cheaper loan.Of course, do consider the tax angle here. Some loans may seem costly, but the tax benefits they offer bring down the effective cost for the borrower. For instance, multiple tax benefits bring down the actual cost of a home loan by sharply reducing your tax liability. Keeping a home loan for longer may yield long-term benefits. Similarly, the interest paid on an education loan is fully tax deductible. If you factor in the tax benefits in the 30% tax slab, an education loan that charges 12% effectively costs 8.5%.Make cash flow adjustmentsBorrowers should also consider liquidating surplus assets or any low-yield investments to pay off their outstandings. Take out profits from your equity mutual fund or gold investments, if any. Surrender costly traditional plans that extract hefty premium but offer very low coverage. “Don’t let any emotional attachment with your assets prevent you from selling them. Getting out of debt should be your first priority,” says Rege.You should also divert all unnecessary expenses towards paying EMIs. Do not splurge on the latest smart phone or newest 4K TV. Consider pre-paying the ongoing loan partially. You may temporarily suspend SIPs to pay EMIs. Lastly, make use of any windfall gains like deferred bonus or increments to repay costly debt.Lenders may even go beyond credit score to assess your creditworthiness. “Underwriting of loans will be based on current cash-flows rather than historic repayment track records. Individuals should maintain healthy bank balances, pay EMIs and other bills on time and check discretionary spending,” says Agrawal. So while borrowers should keep track of their credit scores, it is equally important to maintain healthy cash flows.Finally, do not feel shy to cry out for help if you are unable to figure out a way out of your debt hole. You may approach a debt counselling centre for advice. ICICI Bank’s Disha and Bank of India’s Abhay offer free advice. Others like Credit Vidya and Credit Sudhaar charge a fee for their services. These actively engage with borrowers facing problems with loans.