📘 4.1 The Purpose or Need of Debt
Debt allows individuals to achieve large goals — like home ownership or higher education — that cannot be fully financed by savings alone. When used responsibly, debt can enhance wealth-building and maintain investment continuity:contentReference[oaicite:1]{index=1}.
Most people cannot save enough to buy a house outright. Home loans enable earlier ownership and long-term asset building.
Education loans allow students to invest in their future without liquidating long-term retirement or investment assets.
Loans can help acquire essential personal or professional assets while maintaining cash flow for other needs.
Sometimes, borrowing (leverage) enhances ROI — but only when the expected return is higher than the cost of borrowing.
⚖️ Debt is Not Always Bad
- It becomes a problem only when repayment exceeds income capacity
- Using debt for value-creating assets is considered good debt
- Example: home loans, education loans
📉 Debt Comes With Costs
- Interest charges and EMIs affect cash flow
- Overuse of debt reduces flexibility and creates financial stress
- Credit cards and personal loans are high-cost debt
🛡️ Secured Loans
- Backed by property (mortgage, LAP)
- Lower interest rates due to lender security
- Examples: home loan, loan against FD
⚠️ Use Debt Cautiously
- Don’t use debt for regular expenses or speculative investments
- Emergency or temporary gaps may justify short-term credit
- Evaluate repayment ability before borrowing
Debt can be a growth tool if managed well. The goal is not to avoid debt — but to use it wisely and ensure that repayment is affordable, strategic, and goal-aligned:contentReference[oaicite:2]{index=2}.
📘 4.2 Role and Impact of Debt in Cash Flow Management
Debt is a double-edged sword. It enables access to big goals like homes or education but adds fixed obligations that reduce savings potential. Managing debt within income limits is essential for cash flow health and financial survival:contentReference[oaicite:1]{index=1}.
🛍️ 4.2.1 Consumption vs Investment Expenditure
- Consumption Expenditure: Spent on items that do not generate income (e.g. restaurants, clothes, salons)
- Investment Expenditure: Creates future income (e.g. bonds, mutual funds, education, property)
✨ Pro Tip: Prioritize SIPs and recurring investments first — then plan discretionary expenses. The goal is: Income – Savings = Expenses:contentReference[oaicite:2]{index=2}.
🧾 4.2.2 Identifying Holes in Household Budget
- Mislabeling lifestyle spending as essentials
- Overestimating budgets without tracking actuals
- Not “paying self first” (saving before spending)
- Untracked expenses via cards or UPI
📌 Action: Track all spends over ₹500/₹5,000 (based on income level). End-of-month summaries reveal spending leaks (e.g., gadgets, food delivery):contentReference[oaicite:3]{index=3}.
📊 4.2.3 Allocation to Expense Categories
📌 Mandatory
- Taxes, PF, Loan repayments
- Non-negotiable and fixed
🛒 Essentials
- Rent, groceries, school fees
- Basic monthly lifestyle
🎮 Discretionary
- Dining, subscriptions, new gadgets
- Most flexible and easily reduced
✨ Technique: Try “Zero-Based Budgeting” — every expense must justify its place. Don’t just carry forward past habits:contentReference[oaicite:4]{index=4}.
🎁 4.2.4 Windfalls
- Bonuses, gifts, inheritances, lottery winnings
- Often misused if not pre-allocated
- Should be used to reduce debt or build assets
- Hold in liquid fund until a smart decision is made
⚠️ Avoid: Relying on future windfalls to cover poor money habits. This leads to deeper debt:contentReference[oaicite:5]{index=5}.
📘 4.3 Leverage and Debt Counselling
Leverage is the use of borrowed money to finance personal or investment goals. When used responsibly, it can help grow assets — but excessive or misused leverage leads to repayment stress and financial insecurity:contentReference[oaicite:1]{index=1}.
🎯 4.3.1 Purpose of the Debt
- Debt should support the creation of appreciating or income-generating assets (e.g. home, education)
- Avoid debt for volatile investments (e.g. margin investing in stocks)
- Never use debt for daily expenses — this is a sign of financial distress
- Short-term debt may be fine for temporary liquidity mismatches — but only with a clear repayment plan
💸 4.3.2 Cost of Debt
- Higher interest = higher EMI burden
- Secured loans (home, education) are cheaper than unsecured (credit cards, personal loans)
- Revolving credit (credit cards with partial payment) can cost 42.6%+ annually
- Informal debt (money lenders) can cost up to 60–80% p.a. — avoid at all costs
✨ Pro Tip: Always calculate the effective interest rate — not just monthly percentages:contentReference[oaicite:2]{index=2}.
⏳ 4.3.3 Maturity of Debt
- Short tenure = high EMI but faster clearance
- Long tenure = lower EMI but more interest paid over time
- Repayment capacity & debt-to-income ratio should guide loan tenure decisions
🧠 Insight: A longer loan that you can comfortably repay is safer than a short-tenor one that strains cash flow:contentReference[oaicite:3]{index=3}.
🔁 4.3.4 Debt Re-scheduling
- Rank debt by interest cost. Repay high-cost (credit card, personal loans) first
- Sell underutilized assets to prepay loans (if value justifies)
- Explore lower-cost refinancing (e.g. credit card balance transfer)
- Extend loan tenure to lower monthly EMI (with caution)
- If all else fails: negotiate rescheduling with lender — but note it may impact your credit score
⚠️ Caution: Avoid missing EMIs without communication. Rescheduling is better than default:contentReference[oaicite:4]{index=4}.
📘 4.4 Calculate the Debt Servicing Requirements
Debt servicing refers to all scheduled payments — both interest and principal — made by an individual toward loans or credit obligations. This is a critical input in computing affordability, loan eligibility, and risk evaluation:contentReference[oaicite:1]{index=1}.
🧮 How to Calculate EMI (Monthly Installment)
- Use Excel Formula:
=PMT(rate, nper, -loan) - Example: ₹10 lakh @ 10% for 5 years →
=PMT(0.10/12, 60, -1000000) - Result: ₹21,247
📊 Debt Servicing Ratio
Formula: Monthly Debt Obligations ÷ Monthly Income
Example: ₹60,000 EMI ÷ ₹1,50,000 income = 40%
Tip: If this exceeds 35–40%, lenders consider it risky and may deny new loans or increase interest rate:contentReference[oaicite:2]{index=2}.
💳 4.4.1 Role of Credit Bureaus & Credit Score
- Credit score is based on repayment history, credit mix, usage, and inquiries
- Range: 300 to 900 (CIBIL TransUnion Score)
- Used by banks/NBFCs to decide:
- Loan eligibility
- Interest rate offer
- Credit limit
- Factors that affect score:
- Timely payments → ✔️
- High utilization of credit cards → ❌
- Too many unsecured loans or loan applications → ❌
📌 Caution: Even joint accounts or guaranteed loans affect your score if they default:contentReference[oaicite:3]{index=3}.
🔍 Accessing Your Credit Score
- Visit CIBIL, Experian, Equifax, or CRIF High Mark websites
- Enter PAN, date of birth, email/OTP authentication
- Get credit score + full credit report
- Watch out for fraud links — only access via official bureau/partner banks
- You’re entitled to 1 Free Full Credit Report (FFCR) from each bureau per calendar year
- Includes: Credit score + repayment history + current loan summary
- Must match the report shown to banks when you apply for loans
✨ Tip: Use your FFCR to spot errors, fraud, or outdated loans and raise disputes if needed:contentReference[oaicite:4]{index=4}.
📘 4.5 Responsible Borrowing
Borrowing helps individuals finance important purchases like homes, education, or assets — but only when done within limits. Responsible borrowing means using debt for growth, not lifestyle inflation, and repaying without disrupting financial goals:contentReference[oaicite:1]{index=1}.
✅ Borrow Within Limits
- Don’t borrow more than your income can support
- Stick to a debt-to-income ratio below 35%
- Have a clear EMI plan with savings protection
💳 Use Credit Cards Wisely
- Pay dues in full before due date — avoid minimum balance traps
- Don’t revolve credit unless absolutely necessary
- Keep credit utilization under 30%
📈 Borrow for Growth
- Take loans for value-appreciating assets (home, education)
- Avoid debt for lifestyle or non-essential luxury purchases
- Check ROI vs borrowing cost
📅 Repay Promptly
- Never miss EMI or credit card due dates
- Late payments lower your credit score and attract penalties
- Set auto-pay for mandatory dues if cash flow allows
- Too many unsecured loans (personal loans, credit card EMIs)
- Flashy lifestyle funded by EMIs
- Using debt for daily expenses — this signals a debt trap
- Applying for multiple loans simultaneously → lowers your score
- Borrow only when the asset or experience is meaningful, long-term, and aligned with your goals
- Always understand the full cost of borrowing, including hidden charges
- Revisit your debt portfolio once a year and restructure if needed
📘 4.6 Secured and Unsecured Loans
Loans can be broadly classified into two categories: Secured Loans (backed by an asset) and Unsecured Loans (no collateral involved). The interest rates and risk profiles of these loans differ significantly:contentReference[oaicite:1]{index=1}.
🔐 Secured Loans
- Loan backed by an asset like house, gold, FD, securities
- If borrower defaults, lender can sell the asset to recover dues
- Examples: Home loan, Vehicle loan, Gold loan, Loan against FD/MFs
- ✅ Lower interest rates due to security comfort
- 📉 Better approval chances for large loans
🚫 Unsecured Loans
- No asset pledged — repayment relies on borrower’s credibility
- Higher risk for lender → charged with higher interest
- Examples: Personal loan, Credit card dues, P2P loans
- ❌ More costly than secured loans
- 📉 Easily available but riskier for borrower
- Use secured loans for long-term asset creation — like home or education
- Keep unsecured loans minimal, short-term, and fully repaid each cycle
- For credit cards — always pay full due before interest kicks in
📘 4.7 Terms Related to Loans
🔒 4.7.1 Fixed Rate Loans
Interest rate stays constant for the entire tenure. EMIs remain fixed. Ideal when interest rates are low and stable.
📈 4.7.2 Floating Rate Loans
Interest rate changes periodically with benchmark (like Repo/MCLR). EMI or tenure varies. Suits falling rate environment.
🏠 4.7.3 Home Equity Loan
Loan against an owned property’s value (also called LAP). Property is pledged but not sold. Used for large funding needs.
📦 4.7.4 Hire Purchase
Asset acquired in installments. Ownership transfers only after the final payment. Common in vehicle and durable financing.
📃 4.7.5 Lease
User pays rent to use an asset. Ownership remains with lessor. At end of lease, asset is returned or lease is renewed.
📆 4.7.6 Amortisation
EMI includes both interest and principal. Initial EMIs are interest-heavy. Over time, principal portion increases.
🔁 4.7.7 Refinancing
Old loan is replaced with a new loan (usually at lower rate or extended tenure). Common for home loans and business debt.
💰 4.7.8 Prepayment
Extra payments made towards loan ahead of schedule. Reduces interest burden. Some loans may charge a penalty.
🧾 4.7.9 Pre-EMI Interest
Interest-only payments made before full loan disbursement. Common in under-construction property financing.
🕒 4.7.10 Moratorium
A temporary pause in loan repayments due to special conditions (e.g., COVID). Interest still accrues during this period.
🏦 4.7.11 Mortgage
Loan secured against immovable property. Borrower retains ownership unless default occurs (e.g. home loan).
📌 4.7.12 Pledge
Movable asset is handed over to lender until loan is repaid (e.g. gold loan). Asset stays with lender as security.
🚗 4.7.13 Hypothecation
Asset remains with borrower but lender has charge over it. Used in car loans, inventory finance. Repossession if defaulted.
📘 4.8 Types of Borrowing
🏠 Home Loan
Used to purchase a constructed or under-construction property. Long tenure (up to 30 years). Property documents are held as security:contentReference[oaicite:1]{index=1}.
🎓 Education Loan
Funds higher education. Repayment starts after course completion or when the student begins earning. Interest accumulates during study period.
🚗 Vehicle Loan
Loan for two- or four-wheelers. Hypothecated to lender. Shorter term (3–7 years). Interest increases with tenure. Vehicle is a depreciating asset.
💼 Business Loan
For running a business. Based on working capital needs, turnover, and financial ratios. Can be secured or unsecured depending on the business profile.
💳 Personal Loan
Unsecured loan for any use (travel, wedding, emergency). High interest. Easy to get, but repayment discipline is critical.
📉 Credit Card Debt
Short-term credit with interest-free grace if paid fully. If not, revolving credit attracts 36%–42% annualized interest. Very expensive if misused.
🏦 Overdraft
Allows spending above account balance up to a set limit. Interest charged only on the used amount and duration. Often linked to FD or asset security.
🔐 Loan Against Assets
Secured loan using MF, shares, gold, or property. Loan amount is % of asset value. If asset falls in value, margin call may be raised.
🤝 P2P Loans
Peer-to-peer loans through online platforms. Unsecured, high-risk lending between individuals. High interest rates to compensate for risk:contentReference[oaicite:2]{index=2}.
Use secured loans (home, education) for building long-term value. Unsecured loans (credit card, personal loans) should be avoided for lifestyle expenses or used only in emergencies.
📘 4.10 Loan Restructuring
Loan restructuring is the process of modifying the terms of an existing loan — such as EMI amount, interest rate, or loan tenure — to make it more affordable for the borrower during financial stress:contentReference[oaicite:1]{index=1}.
⚠️ When Is It Needed?
- Job loss or income reduction
- Business downturn or temporary illness
- To avoid loan becoming a non-performing asset (NPA)
⏳ Tenure Extension
Effect: Lowers EMI but increases total interest paid
Example: ₹3 lakh @ 7% for 3 yrs → EMI = ₹9,263
Extended to 5 yrs → EMI = ₹5,940
=PMT(0.07/12, 60, -300000)
💸 Interest Rate Reduction
Effect: Saves on interest without changing loan duration
Example: 7% rate → EMI = ₹9,263
New 5% rate → EMI = ₹5,994
=PMT(0.05/12, 36, -300000)
🎯 Principal Haircut
Effect: Lender agrees to reduce outstanding loan
Example: Loan reduced from ₹3L to ₹2L → EMI = ₹6,175
=PMT(0.07/12, 36, -200000)
🔄 Loan Swap or Refinance
Effect: Costlier loan replaced by cheaper one (e.g., credit card to personal loan)
Note: Refinance must maintain or improve the borrower’s debt servicing ratio
The restructured EMI must ensure that the present value of all future payments is equal to or near the original loan value. If EMI becomes too low or duration too long, lender may lose money unless compensated with more interest:contentReference[oaicite:2]{index=2}.
- Communicate with lenders early before default
- Request restructuring with proof of financial change
- Always check the revised EMI’s affordability
- Understand long-term cost (more interest or lower credit score)
📘 4.11 Repayment Schedules with Varying Interest Rates
EMI consists of two parts: interest + principal repayment. While the EMI may appear constant, the proportion of these two components varies depending on the interest rate. Understanding this breakdown helps borrowers evaluate the true cost of borrowing over time:contentReference[oaicite:1]{index=1}.
🔢 EMI Breakdown Using Excel
Loan Example: ₹10,00,000 at 7% for 10 years (120 months)
Monthly EMI (using PMT): =PMT(0.07/12, 120, -1000000) → ₹11,610
First Month Breakdown:
- Principal (PPMT):
=PPMT(0.07/12, 1, 120, -1000000)→ ₹5,777 - Interest (IPMT):
=IPMT(0.07/12, 1, 120, -1000000)→ ₹5,833
Total: ₹5,777 (principal) + ₹5,833 (interest) = ₹11,610
📉 5% Interest Scenario
- EMI: ₹10,606
- Principal repaid (first month): ₹6,440
- Interest: ₹4,166
- ✨ More of EMI goes toward principal early on
📈 9% Interest Scenario
- EMI: ₹12,667
- Principal repaid (first month): ₹5,167
- Interest: ₹7,500
- ⚠️ Most EMI goes to interest early on
A higher interest rate means a larger share of EMI goes toward interest in the beginning, slowing down debt reduction. Lower rates shift the benefit to the borrower by accelerating principal repayment:contentReference[oaicite:2]{index=2}.
📘 4.13 Change in EMI or Tenure due to Interest Rate Changes
Floating rate loans are linked to external benchmarks like the repo rate. When the rate changes, borrowers must choose between two options: (a) Increase or decrease the EMI, or (b) Change the loan tenure:contentReference[oaicite:1]{index=1}.
– EMI will increase if tenure remains unchanged
– If EMI is fixed, tenure will be extended
– This increases overall interest paid
– EMI can remain same but tenure reduces
– Or EMI can be reduced while tenure stays fixed
– Reduces total interest burden
🧠 How to Decide Between EMI and Tenure Change?
- If your cash flow is tight → Keep EMI fixed, extend tenure
- If you want to save interest → Increase EMI, keep tenure same
- Monitor your total interest cost over time
- Always ask lender for amortization schedule under new terms
A borrower pays ₹20,000 EMI. If interest rises by 1%, EMI increases to ₹21,385. They can either:
- Pay the new EMI → tenure remains the same
- Keep paying ₹20,000 → loan will now take longer to repay
Tip: Use Excel =PMT and =NPER to simulate scenarios
📘 4.14 Invest the Money or Pay Off Outstanding Loan
If you receive a windfall (bonus, inheritance, maturity proceeds), should you invest it or use it to repay a loan? The answer depends on financial strain, math comparison, and mental comfort:contentReference[oaicite:1]{index=1}.
💼 1. Financial Strain
If EMI is too high or causing stress, repay the loan first. Relief from mental pressure may outweigh return opportunities.
📊 2. Investment vs Loan Rate
Compare expected investment return (post-tax) with loan interest (post-tax).
Invest if ROI > loan rate. Repay if loan rate > ROI.
📏 3. Size of Windfall
If windfall is small relative to the loan — investing may make more sense.
If windfall is a large chunk of the loan, repayment leads to early debt freedom.
📈 4. Compounding Effect
Investment grows over time. If left to compound at 12% while loan costs 7%, long-term wealth creation beats early repayment.
⚠️ 5. Risk of Investment
Equity investment may yield 12%, but comes with risk. If you need certainty, repaying loan offers guaranteed saving of interest outflow.
Loan: ₹5,00,000 @ 10%
Windfall: ₹2,50,000
Investment return expected: 12%
→ Mathematically better to invest — but emotionally better to prepay if stress is high.
- Split the amount: repay part of the loan and invest the rest
- Use compounding calculators to compare 5–10 year outcomes
- Always consider tax impact on both investment and loan interest
- Emergency fund should be in place before either action
📘 4.15 Strategies to Reduce Debt Faster
Debt reduction strategies help accelerate freedom from liabilities. Each strategy has a different focus — interest rate, emotional momentum, or blended logic. The best approach depends on the borrower’s goals, discipline, and debt structure:contentReference[oaicite:1]{index=1}.
📊 4.15.1 Avalanche Strategy
- Prioritize debts with highest interest rates first (e.g. credit card > personal loan > car loan)
- Mathematically the most cost-effective method
- Reduces total interest burden over time
- Risk: If high-interest loans are small in size, the psychological impact may be low
Example: Pay off 42% credit card first → then 21% personal loan → then 12% car loan → finally 8% housing loan
❄️ 4.15.2 Snowball Strategy
- Pay off loans with the smallest outstanding balance first
- Builds emotional momentum and motivation
- Good for people with many debts and low discipline
- Drawback: Higher interest debts may linger longer, increasing total cost
Example: Clear ₹30,000 credit card (smallest) first → then ₹1 lakh car loan → then personal loan → then home loan
🌨️ 4.15.3 Blizzard Strategy
- Combination of Snowball and Avalanche
- Start with smallest loan to gain confidence
- Then switch to highest-interest loans for max savings
- Balances motivation with cost-effectiveness
Example: Pay off smallest loan first for quick win → shift to highest interest loan → continue by priority
- Use windfalls to make extra repayments
- Refinance high-interest loans when possible
- Avoid taking new loans unless necessary
- Track your progress monthly for motivation
