BlogInvestment Adviser Level 14. Debt Management and Loans

4. Debt Management and Loans

The purpose or need of debt

The purpose or need of debt can vary depending on the individual or organization. Some common reasons for taking on debt include:

  1. Financing large purchases: Debt can be used to finance large purchases that an individual or organization may not have the cash on hand to pay for upfront, such as a house or a car.
  2. Starting or growing a business: Many entrepreneurs take on debt to start or grow their businesses, such as borrowing money to purchase inventory or expand their operations.
  3. Investing in education: Student loans are a common form of debt that can be used to finance education and improve one’s job prospects and earning potential.
  4. Managing cash flow: Some organizations may use debt to manage their cash flow and maintain their operations during periods of low revenue or unexpected expenses.

Role and Impact of Debt in cash flow management

While debt can be useful in achieving certain goals, it’s important to manage it responsibly and avoid taking on too much debt. High levels of debt can lead to financial stress, difficulty making payments, and even bankruptcy. It’s important to carefully consider the risks and benefits of taking on debt before making any financial decisions.

Debt can play a significant role in cash flow management. When used responsibly, debt can help individuals or organizations achieve their goals by allowing them to make investments or purchases that they may not have the cash to pay for upfront.

For example, taking out a mortgage to purchase a home can provide a long-term asset that can appreciate in value over time, while also providing a place to live. Similarly, taking out a business loan can help small business owners invest in their business, purchase inventory, or expand their operations.

However, debt can also have a negative impact on cash flow management if not managed carefully. High levels of debt can lead to high-interest payments, which can eat into cash flow and reduce the amount of money available for other expenses or investments. Additionally, missed or late payments on debts can lead to penalties and fees, further damaging cash flow.

Therefore, it is important to carefully consider the role and impact of debt in cash flow management and to only take on debt when it is necessary and manageable. Proper debt management strategies, such as creating a budget, monitoring expenses, and making regular payments, can help individuals and organizations effectively manage their debts and maintain positive cash flow.

Leverage and Debt Counselling

Leverage refers to the use of borrowed funds or debt to increase the potential return on investment. While leveraging can help individuals and organizations achieve financial goals, excessive or poorly managed debt can lead to financial distress.

Debt counseling is a service provided to individuals and organizations to help them manage their debt and develop a plan to become debt-free.

The purpose of debt is to finance investments or purchases that an individual or organization may not have the funds to pay for upfront. For example, taking out a mortgage to buy a house or a loan to start a business. Debt can also be used to manage cash flow by providing immediate access to funds while waiting for future income.

The cost of debt includes interest payments, fees, and penalties. High-interest rates or late fees can quickly add up and make it difficult to repay the debt.

The maturity of debt refers to the length of time before the debt must be repaid in full. Short-term debt has a maturity of less than one year, while long-term debt has a maturity of more than one year. The maturity of debt can affect cash flow management, as short-term debt must be repaid more quickly and can put pressure on cash reserves.

Debt rescheduling is a process where a borrower and lender agree to change the terms of the debt, such as extending the maturity date, lowering interest rates, or reducing payments. Debt rescheduling can help manage cash flow and make debt payments more manageable, but it can also lead to additional fees and interest charges.

Calculate the debt servicing requirements

Role of Credit Bureaus and Credit Scores:
Credit bureaus collect and maintain information about individuals’ credit history and use this information to calculate their credit scores. Credit scores are used by lenders to assess the risk of lending money to an individual. A high credit score indicates that the individual is more likely to pay back their debts on time and is therefore considered a lower-risk borrower.

Accessing your credit score:
Individuals can access their credit scores from credit bureaus such as CIBIL, Experian, Equifax, and CRIF High Mark. These bureaus provide credit reports that contain information about an individual’s credit history, including their credit score. These reports can be obtained for a fee or sometimes for free, as mandated by RBI’s regulations.

RBI’s regulation about free credit score:
In 2016, RBI mandated that credit bureaus provide individuals with one free credit report per year upon request. This allows individuals to monitor their credit history and identify any errors or fraudulent activity. In addition, RBI has mandated that credit bureaus provide a free credit report to individuals who have been denied credit, as well as to individuals whose credit reports have been adversely affected by fraud or identity theft.

Responsible Borrowing

Responsible borrowing refers to the practice of taking on debt in a thoughtful and strategic manner, with a focus on long-term financial stability. It involves carefully considering the terms of a loan or credit agreement, as well as one’s ability to make timely payments and manage the debt effectively.

Some tips for responsible borrowing include:

  1. Understanding your current financial situation: Before taking on debt, it’s important to have a clear understanding of your current financial situation, including your income, expenses, assets, and liabilities.
  2. Setting realistic borrowing goals: Determine how much money you need to borrow and create a repayment plan that aligns with your income and expenses.
  3. Comparing loan options: Shop around and compare loan options to find the best terms and interest rates that work for you.
  4. Reading the fine print: Always read the terms and conditions of a loan or credit agreement carefully, including any fees, penalties, or other costs associated with the loan.
  5. Making timely payments: Always make your loan payments on time to avoid late fees and penalties, and to maintain a good credit score.
  6. Avoiding overborrowing: Only borrow what you can realistically afford to repay, and avoid taking on more debt than you need.

By following these tips, you can borrow responsibly and manage your debt effectively, while maintaining long-term financial stability.

Secured and Unsecured loans

Secured and unsecured loans are two types of borrowing that differ in terms of the collateral required and the risk involved for both the borrower and the lender.

Secured loans require collateral, which is an asset that the borrower pledges as security for the loan. If the borrower is unable to repay the loan, the lender has the right to seize the collateral to recover the amount owed. Common examples of secured loans include home mortgages and car loans, where the property being financed serves as collateral. Because there is less risk for the lender, secured loans typically have lower interest rates and longer repayment terms.

Unsecured loans, on the other hand, do not require collateral and are based solely on the borrower’s creditworthiness and ability to repay the loan. Common examples of unsecured loans include personal loans, credit card loans, and student loans. Because the lender is taking on more risk without any collateral, unsecured loans typically have higher interest rates and shorter repayment terms.

When deciding between a secured or unsecured loan, it is important to consider your own financial situation, the amount you need to borrow, and the terms and interest rates offered by lenders. If you have valuable assets to offer as collateral, a secured loan may be a good option, as it can provide you with lower interest rates and longer repayment terms. However, if you do not have any collateral, an unsecured loan may be your only option, but it will likely come with higher interest rates and shorter repayment terms. It is important to evaluate your ability to repay any loan before taking on debt, regardless of whether it is secured or unsecured.

Terms related to loans

Term Description
Fixed Rate Loans Loans with a fixed interest rate for the entire term of the loan.
Variable or Floating Rate Loans Loans with an interest rate that fluctuates based on market conditions.
Home Equity Loan A loan secured by the borrower’s equity in their home.
Hire Purchase A type of loan where the borrower hires an asset from a lender with an option to buy it at the end of the term.
Lease A contract where the borrower rents an asset from a lender for a fixed term.
Amortisation The process of paying off a loan through a series of regular payments.
Refinancing The process of replacing an existing loan with a new loan with better terms.
Prepayment When a borrower pays off a loan before the end of the term.
Pre EMI Interest When a borrower pays only the interest on the loan amount for a certain period before starting to pay the principal.
Moratorium A period of time during which the borrower is not required to make loan payments.
Mortgage A loan secured by the borrower’s property.
Hypothecation A process where a borrower pledges an asset as collateral for a loan without transferring ownership of the asset.

Types of borrowing

Type of Loan Description Pros Cons
Home Loan Loan taken for the purpose of purchasing or constructing a home Long repayment tenure, lower interest rates, tax benefits Requires collateral, processing fees, pre-payment penalties
Education Loan Loan taken for the purpose of higher education No collateral required, tax benefits, flexible repayment options Higher interest rates, limited loan amount
Vehicle Loan Loan taken for the purpose of purchasing a vehicle No collateral required, flexible repayment options, fast processing time Higher interest rates, depreciation of the vehicle value, processing fees
Business Loan Loan taken for the purpose of starting or expanding a business Flexible repayment options, can be used for various purposes Requires collateral, higher interest rates, processing fees
Personal Loan Loan taken for personal expenses such as wedding, travel, medical emergencies etc. No collateral required, fast processing time, flexible repayment options Higher interest rates, limited loan amount
Credit card loan Loan taken by using a credit card No collateral required, easy access to credit, flexible repayment options Higher interest rates, additional fees and charges, risk of accumulating high debt
Overdraft Loan taken by overdrawing from a bank account Flexibility to repay, interest charged only on the amount borrowed Higher interest rates, additional fees and charges, risk of accumulating high debt
Loan against securities, gold, property etc. Loan taken by pledging securities, gold, property etc. as collateral Lower interest rates, higher loan amount Risk of losing collateral, processing fees, pre-payment penalties
P2P loan Loan taken from individuals through a P2P lending platform Faster processing time, flexible repayment options Higher interest rates, risk of default by lenders

Understand loan calculations

Calculate EMI using the PMT function in Excel:

Assuming a loan amount of Rs. 1,00,000, an interest rate of 10% per annum and a loan tenure of 2 years (24 months), the EMI calculation can be done as follows:

Loan Amount (Rs.) Interest Rate (per month) Loan Tenure (months) EMI (Rs.)
1,00,000 0.0083 (10%/12) 24 -3,825.51

To calculate the EMI, use the following PMT formula in Excel:

=PMT(rate, nper, pv, [fv], [type])

where:

  • rate: The interest rate per period (in our case, the monthly rate of 10%/12 = 0.0083)
  • nper: The total number of payment periods (in our case, 24 months)
  • pv: The present value of the loan (in our case, Rs. 1,00,000)
  • fv (optional): The future value of the loan (default is 0)
  • type (optional): When payments are due (0 for end of period, 1 for beginning of period; default is 0)

So, the formula to calculate EMI, in this case, would be:

=PMT(0.0083, 24, 100000)

This will give us the value of EMI as -3,825.51 (negative value indicates outgoing cash flow).

Therefore, the borrower would need to pay an EMI of Rs. 3,825.51 per month for a period of 24 months to repay the loan amount of Rs. 1,00,000 at an interest rate of 10% per annum.

Loan restructuring

Loan restructuring involves changing the conditions of an existing loan to make it affordable for the borrower who may be facing financial stress. This can be done by reducing the EMI or extending the repayment period. The present value of all future payments must be considered to determine the value of the restructuring. A reduction in the number of instalments or interest rate can also help the borrower save on payments. However, it’s important to ensure that the restructuring does not put a higher burden on the borrower. Calculating the present value of cash flows is essential to determine the right amount to be paid during the restructuring process.

Example of using Excel formula (PMT) for EMI calculation:

Assume a loan amount of Rs. 500,000 with an interest rate of 9% per annum and a loan tenure of 5 years (60 months). The monthly EMI payment can be calculated using the following formula:

=PMT(9%/12,60,500000)

The result will be -Rs. 10,475.45, which is the monthly EMI payment.

Similarly, let’s consider an example for loan restructuring. Assume that a borrower has taken a loan of Rs. 300,000 for a period of 3 years with an interest rate of 7% per annum. The monthly EMI payment for this loan is Rs. 9,263. However, due to financial stress, the borrower is unable to pay the EMI and requests for loan restructuring.

The lender agrees to reduce the loan amount to Rs. 200,000 and keep the loan tenure same as 3 years. The revised monthly EMI payment can be calculated using the following formula:

=PMT(7%/12,36,200000)

The result will be -Rs. 6,175.07, which is the new monthly EMI payment. This reduction in the EMI payment will help the borrower in managing their finances better.

Repayment schedules with varying interest rates

Repayment schedules with varying interest rates can be calculated using the PMT function in Excel. The PMT function can calculate the fixed periodic payment required to pay off a loan with a constant interest rate over a set period of time.

To calculate a repayment schedule with varying interest rates, you will need to use a different interest rate for each period. Here’s an example:

Suppose you take out a loan of Rs. 1,00,000 with a repayment period of 5 years. The interest rate for the first year is 10%, for the second year it is 12%, for the third year it is 9%, for the fourth year it is 11%, and for the fifth year it is 8%.

To calculate the repayment schedule using Excel, you can use the following formula:

=PMT(rate,nper,pv,fv,type)

where:

  • rate is the periodic interest rate
  • nper is the total number of payment periods
  • pv is the present value of the loan
  • fv is the future value of the loan (which is usually set to 0)
  • type is the timing of the payment (which is usually set to 0 for end-of-period payments)

To calculate the repayment schedule for the first year, you would use a rate of 10%, a nper of 12 (since there are 12 payment periods in a year), a pv of Rs. 1,00,000, a fv of 0, and a type of 0. The formula would look like this:

=PMT(0.10/12,12,100000,0,0)

This would give you a monthly payment of Rs. 2,124.02 for the first year.

To calculate the repayment schedule for the second year, you would use a rate of 12%, a nper of 12, a pv of the remaining loan balance from the end of the first year (which is Rs. 80,623.05), a fv of 0, and a type of 0. The formula would look like this:

=PMT(0.12/12,12,80623.05,0,0)

This would give you a monthly payment of Rs. 2,230.12 for the second year.

You would repeat this process for each year of the loan, using the appropriate interest rate for each year and the remaining loan balance from the end of the previous year as the present value for the PMT function. This would give you a repayment schedule with varying interest rates.

Criteria to evaluate loans

When evaluating loans, there are several criteria that are important to consider. These include:

  1. Interest rate: The interest rate is the cost of borrowing money and is an important factor to consider when evaluating loans. A lower interest rate means a lower cost of borrowing, which can save you money in the long run.
  2. Loan term: The loan term is the length of time you have to repay the loan. Longer loan terms can result in lower monthly payments, but may also result in paying more in interest over the life of the loan.
  3. Fees: Fees associated with the loan can add to the overall cost of borrowing. Examples of fees include origination fees, application fees, and prepayment penalties.
  4. Collateral: If the loan is secured by collateral, such as a house or a car, it can result in a lower interest rate compared to an unsecured loan. However, if you are unable to repay the loan, the lender can take possession of the collateral.
  5. Credit score: Your credit score can impact the interest rate you receive on a loan. A higher credit score can result in a lower interest rate, while a lower credit score may result in a higher interest rate or difficulty in obtaining a loan.
  6. Monthly payments: It is important to consider the monthly payments you will need to make when evaluating loans. Can you afford the monthly payments without compromising your other financial obligations?

By considering these criteria, you can make an informed decision when evaluating loans and choose the one that best fits your financial situation.

Opting for change in EMI or change in tenure for interest rate changes

When there is a change in interest rates, borrowers often consider two options: changing the Equated Monthly Installment (EMI) or changing the tenure of the loan. Let’s understand both options and their implications:

  1. Changing the EMI:
    When there is a change in interest rate, the borrower may choose to keep the same tenure of the loan but change the EMI amount. This means that the borrower will pay a higher or lower EMI depending on whether the interest rate has increased or decreased. By doing so, the borrower will pay the loan off faster or slower, respectively.
  2. Changing the tenure:
    Another option is to keep the EMI amount fixed and change the tenure of the loan. This means that if the interest rate goes up, the borrower can choose to increase the tenure of the loan, thus lowering the EMI. Conversely, if the interest rate goes down, the borrower can choose to decrease the tenure of the loan, thus increasing the EMI. By doing so, the borrower can keep the monthly EMI payment the same, but the overall interest paid will increase or decrease accordingly.

It’s important to note that when choosing between these two options, borrowers should consider their overall financial situation and choose the option that is most feasible for them. Changing the EMI may be more suitable for borrowers who have a higher income or can afford to pay a higher EMI. Changing the tenure may be more suitable for borrowers who have a lower income or need to keep their monthly expenses fixed. Additionally, borrowers should consider the overall interest paid over the life of the loan when making this decision.

Invest the money or pay off outstanding loan

When deciding whether to invest money or pay off an outstanding loan, there are several factors to consider.

  1. Interest rates: Compare the interest rate on the loan with the potential return on the investment. If the interest rate on the loan is higher than the potential return on the investment, it may be wise to pay off the loan first.
  2. Type of loan: Different types of loans have different interest rates and terms. For example, credit card debt typically has a higher interest rate than a mortgage or car loan. Consider paying off high-interest debt first before investing.
  3. Financial goals: Consider your financial goals when deciding whether to invest or pay off debt. If your goal is to save for retirement, investing may be a better option. If your goal is to become debt-free, paying off debt may be a priority.
  4. Available funds: Consider the amount of money you have available to invest or pay off debt. If you have a large amount of debt, it may be more beneficial to pay off debt first before investing.

Ultimately, the decision to invest or pay off debt will depend on your personal financial situation and goals. It is important to carefully consider all factors and make an informed decision.

Strategies to reduce debt faster

Here are the three common strategies to reduce debt faster:

  1. Avalanche Method: In this method, you prioritize paying off the debt with the highest interest rate first while making minimum payments on other debts. Once the first debt is paid off, you move on to the debt with the next highest interest rate and so on until all debts are paid off. This method saves the most money on interest charges over time.
  2. Snowball Method: In this method, you prioritize paying off the debt with the lowest balance first while making minimum payments on other debts. Once the first debt is paid off, you move on to the debt with the next lowest balance and so on until all debts are paid off. This method provides a psychological boost as you see debts getting paid off faster, but it may cost more in interest charges over time.
  3. Blizzard Method: This method is a combination of the avalanche and snowball methods. You focus on paying off the debt with the highest interest rate and the lowest balance simultaneously. This method provides a balance between saving on interest charges and gaining a psychological boost from paying off debts faster.

Mock Test:-

0 votes, 0 avg
0

Investment Advisor Level 1

CHAPTER 4: DEBT MANAGEMENT AND LOANS

1 / 65

1. Which function in MS Excel is used to calculate the Equated Monthly Installment (EMI)?

2 / 65

2. If the borrower has another loan with a monthly repayment of Rs. 1,000, what is the new debt servicing ratio?

3 / 65

3. Which type of loan is backed by an asset as security?

4 / 65

4. What makes unsecured loans costlier compared to secured loans?

5 / 65

5. In the Avalanche debt repayment strategy, which loans would be prioritized for repayment?

6 / 65

6. Which type of loan is used to fund the cost of education?

7 / 65

7. What is a feature of education loans regarding repayment?

8 / 65

8. In the avalanche mode of repayment of a loan, the amount paid first is the

9 / 65

9. When deciding whether to invest money or pay off an outstanding loan, which factor should be considered if the loan burden is high?

10 / 65

10. What are the two choices available to a borrower when the interest rate changes in a floating rate loan?

11 / 65

11. How does credit score influence loan applications?

12 / 65

12. Income from investments would be found in the

13 / 65

13. The following is not a liquid asset

14 / 65

14. What is a home equity loan also known as?

15 / 65

15. How does higher interest rate affect debt repayment?

16 / 65

16. What makes personal loans more expensive compared to other loans?

17 / 65

17. Which of the following is an unsecured loan

18 / 65

18. Mutual funds are found in the Balance Sheet as

19 / 65

19. Mr. Khanna requires Rs.10 lakhs in six months' time to pay his son's admission fees. An appropriate investment to set aside money for his goal would be

20 / 65

20. How can the Equated Monthly Installment (EMI) be calculated in MS Excel?

21 / 65

21. How does the payment cycle affect the effective borrowing cost for the borrower?

22 / 65

22. In a P2P lending process, the lender is

23 / 65

23. What is the EMI amount for a loan of Rs. 10 lakh with an interest rate of 7% to be repaid over 10 years (120 months)?

24 / 65

24. What is the typical repayment period for a home loan?

25 / 65

25. What is the key difference between a lease and a hire purchase?

26 / 65

26. Which of the following is not a part of the financial planning process?

27 / 65

27. What is leverage in the context of debt?

28 / 65

28. Which type of loan is preferred when borrowers expect interest rates to decrease?

29 / 65

29. What does the monthly payment amount represent in the loan instalment?

30 / 65

30. What categories can outflows be allocated to in a monthly summary?

31 / 65

31. What are some common errors that make it seem as if savings are not possible?

32 / 65

32. In the example, if the interest rate is lowered to 5%, what is the principal repaid in the first installment?

33 / 65

33. Which debt repayment strategy aims to achieve a sense of success by starting with the lowest debt amount?

34 / 65

34. Which function in MS Excel is used to calculate the principal part of the repayment?

35 / 65

35. How does debt impact cash flow management?

36 / 65

36. Which of the following is an example of other debt?

37 / 65

37. What is one criteria to evaluate loans mentioned in the given details?

38 / 65

38. An ordinary annuity is received at the

39 / 65

39. Which debt repayment strategy focuses on paying off the smallest debt first to gain momentum?

40 / 65

40. What is the main characteristic of credit card debt?

41 / 65

41. How is the equated instalment affected when the loan repayment tenor is increased?

42 / 65

42. What factors affect a person's credit score?

43 / 65

43. How can the debt servicing ratio be reduced in loan repayment?

44 / 65

44. A car loan is usually under

45 / 65

45. What should be considered when deciding whether to invest or pay off an outstanding loan?

46 / 65

46. What is the logical strategy for paying off debt that focuses on repaying loans with the highest interest rates first?

47 / 65

47. How should debt be used to acquire assets?

48 / 65

48. What type of loan has a fixed interest rate for the entire duration?

49 / 65

49. Which loan is taken for the purpose of purchasing a vehicle?

50 / 65

50. Which debt repayment strategy combines the Snowball and Avalanche methods, starting with the lowest debt and then switching to the highest interest rate debt?

51 / 65

51. What is a potential solution for managing debt repayments?

52 / 65

52. How can cheaper re-financing help in managing debt?

53 / 65

53. How does the tenor of a loan affect repayment obligations?

54 / 65

54. How can an advisor help in managing household expenses?

55 / 65

55. What is the potential impact of extending the tenor of a loan?

56 / 65

56. What is the debt servicing ratio if the borrower earns Rs. 10,000 per month and the monthly EMI is Rs. 2,2244?

57 / 65

57. What is the debt-to-income ratio (DTI)?

58 / 65

58. Which function in MS Excel is used to calculate the interest component of the repayment?

59 / 65

59. What is a recommended approach for handling windfall gains?

60 / 65

60. If the debt was taken for purchasing an asset, what can be done to manage the debt?

61 / 65

61. Which factor should individuals consider for responsible borrowing?

62 / 65

62. What is the difference between consumption and investment expenditure?

63 / 65

63. What is the impact of a higher interest rate on debt?

64 / 65

64. Which type of loan is taken for the purchase of a house property?

65 / 65

65. How can individuals access their credit score?

Your score is

The average score is 0%

0%

Add a Comment

You must be logged in to post a comment