Household Debt: How To Identify High-Debt Signs, 5 Ways To Borrow Less & Save More

The indebtedness of Indian households has been on an upward trajectory reflecting a financial deepening among the masses, according to RBI’s July bulletin issued on Thursday. The understanding of ‘how much debt is too much debt’ is crucial for households to recognise alarming patterns that lead individuals towards a debt trap. Households with a fixed income, often encounter a debt-lock situation, especially in the event of organising significant but expensive events for families such as weddings. A debt situation can be spurred by multiple factors from irresponsible borrowing to lack of financial planning.

RBI economists note that households form the bedrock of any macroeconomic framework as the key drivers of consumption, savings, and overall economic activity. The July Bulletin noted that the banking sector in India dominates as a supplier of credit to households with almost 80 per cent share in the total credit. Non-bank entities i.e., HFCs and NBFCs are also emerging fast as the source of credit in recent years, it notes wherein the share of non-bank debt increased by around 7.0 percentage points from end-March 2012 to end-March 2023.

If your household survives on a fixed salary and has to take credits for extra spending, the bane of your financial security is mostly those EMIs. 

How can you identify if your family is under a high debt strain

S Ravi former chairman of BSE and Founder of Ravi Rajan & Co. lists two rules that serve as a financial indicator of a debt trap:

1. EMI exceeding 50 per cent of your income

2. Fixed expenses being more than 70 per cent of income (such as obligations towards rent, maintenance expenses, fees towards education, etc. including EMIs).

In other words, when your Total Fixed Obligations (TFO) as a proportion of your monthly income crosses 70 per cent, it is another early warning signal that one may be entering a debt trap.

High Refinancing Ratio: When households have to constantly refinance their loan outstanding by taking on another loan, it is usually an indication that they are facing difficulty servicing their current outstanding commitments from a fixed monthly income stream.

Bad Credit Score: Failing to settle your credit card bills in full is a significant sign of moving towards a debt-trap situation.

Also read; Burdened By Credit Card Debt? 5 Lifelines To Save Your Finances

How to calculate your debt-to-income ratio?

The debt-to-income ratio is calculated by totalling up all the EMI and then dividing the same by monthly income to arrive at a % value. Says Abhishek Kumar, Sebi RIA (SahajMoney), “One should target to keep this ratio between 20 per cent to 35 per cent.”

5 Ways To Borrow Less & Save More

Debt can be good for the finances of your household if it contributes towards further building wealth. Taking a loan to build or buy your house, education of children, meeting basic family needs (cars for transportation), etc. would be ‘good debt’ as they would be an asset value or contribute towards the betterment of your financial situation as a whole either in a short or long term.

However, other kinds of debt, such as high-interest credit card debt, excessive borrowing, and unmet EMI dues are not so healthy for your finances. Following are a few ways that can help you borrow less and save more:

Identify Your Spends: To effectively manage and reduce debt you first need to identify your spending pattern. “One should categorise their spend into mandatory and discretionary,” Abhishek Kumar, CFA states.

Aim to reduce your discretionary spending while increasing your monthly surplus. Later you can use this surplus to repay high-interest debts such as credit card bills or personal loans.

Debt Avalance Road: Prioritise loan repayments that have high interest rates as they cost more over time. “Replace/repay your highest-cost debt first such as over-due credit card outstanding or other high-cost personal loans and then move on to repaying other outstanding loans,” says Naresh Bulchandani, CFA (Merisis Wealth).

Have an Emergency Fund: It is crucial to build an emergency fund for your household that can take care of certain fixed expenses for at least 6 months in view of unforeseen circumstances.

“Everything looks easy when forecasting on an Excel sheet but then life happens. You could lose your job, get sick, or have an accident – all of which could affect your earning capability in the short term which will put an added burden on your finances,” Bulchandani told Outlook Money highlighting the significance of having an emergency fund.

Keep the Good Debts: ‘Stay in debts that provide tax benefits such as home loans and education loans,’ S Ravi advises. As an individual, you should ensure to repay the minimum due on credit cards and avoid late fees or penal interest rates. Other than this, take appropriate insurance covers to safeguard your family against emergencies.

Every household must do a cost-benefit analysis of investing in fixed deposits against repayment of loans.

Save First, Spend Later: You can build a healthy borrowing and spending habit by making a point of spending what is left after saving from income instead of saving what is left after spending. “This way you could avoid the trap of spending on things on credit and then falling behind on debt payment,” Kumar states.

Managing household debt needs a proactive approach and disciplined financial habits by all earning and non-earning individuals in the family. You should identify high-debt signs early and implement strategies to borrow less and save more to achieve better financial health and reduce the stress associated with debt.