Your Money: Are you sure your loan will not turn into a debt trap?

By Manjula Shastri

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Individual borrowing patterns in any economy is majorly dependent on prevailing socio economic structures. This can be understood by the virtue of having an approach of classifying the end use of the loan as a necessity or attaining luxury. A loan for acquiring a house will fall into the category of necessity. However, purchasing any high-end electronic gadget on high interest EMIs will fall in the category of luxury. Hence, while it is imperative to take loans, timely repayment is vital to avoid debt traps.

Cost of borrowing is primarily dependent on the tangible collateral coverage of the loan. A housing loan is lent on a very low interest rate of 8-10%, but personal loan carries interest rate of 12-24%. Therefore, correct mix of loans and proper classification of required expenses as per urgency and affordability should be addressed.

Market economy
We are witnessing a growing middle class population and a huge employable young workforce which is leading to new heights of consumerism in sectors such as real estate, automobiles, electronics and other household items. Eventually, various credit card companies and numerous NBFCs jump into the market. The existence and survival of such companies is dependent on the spending habits and patterns of individuals. Aggressive marketing of consumer products is a prominent feature that intends to lure the huge number of customers and their disposable household income.

Loans from financial institutions come with ‘easy EMIs’ and many of the NBFCs are located within the shopping complexes selling consumer durables, making it easier for consumers to borrow. But though these loans are sold with features like ‘easy EMIs’, they come with high interest rates between 18-25%. So, debt at such exorbitant cost should be repaid faster and promptly. Doing so will not only help save on interest outgo, but also cut on unwarranted expenses.

Impulsive shopping and borrowing based on future income can lead to a debt trap. We always hope for the best and don’t consider possible problems that may emerge in the future. The concept of prudence, factoring in all possible losses and ignoring all possible gains helps in avoid debt burdens. So, any borrowing should be based on current income and not on anticipated bonus and increments.

Agricultural economy
Rural India constituted 65.53% of the country’s population in 2019. A sizable population of small and marginal farmers is stuck in a vicious cycle of expensive debt in the unorganised money market due to absence of effective microfinance institutions and strong banking services. The interest rate on such borrowing compounds up to2-5 % per month. Long-term crops take 12 to 24 months for encashment and farmers need funds to meet agronomic and personal expenses. Hence their borrowing grows exponentially while the value of their crop remains uncertain due to lack of a robust supply chain mechanism.

If the value of produce is way below that of the liabilities, what prompts lenders to extend credit to the farmers? Land has the highest proportion in the total asset value. Apparently, rising prices of land assure the lender of its value as security against loan which leads to the tragic outcome of never-ending indebtedness. There are provisions of subsidised loans such as Kisan Credit Card, Agri Gold Loans, etc., from various government agencies which can loosen the noose of high-cost debts.

Irrespective of the economic strata, one should be wise enough to identify financial requirement and debt repayment capacity without getting into the psychological trap of societal pressure, marketing gimmicks and aimless buying. Financial literacy and financial awareness is the key to achieve financial freedom.

The writer is associate professor, department of finance, Amity Business School