Debt/Loan Restructuring
Debt restructuring is often resorted to as a debt relief option to pay off loans or to get rid of credit card debt. It is nothing but taking a new loan to pay off new creditors sometimes. When an individual approaches the bank/financial institution for debt restructuring, it results in reduction of total amount of monthly instalments or payment, reduction of outstanding principal amount and/or reduction or waiver of interest to be paid over time.
The Economic crisis faced by people across the globe due to Covid-19 has made many realise that financial troubles are not just faced by the poor or middle class alone. All those who took loans of a larger amount also had to restructure their loans and had to consider alternative plans to shed off their debts. Those who are in financial distress or whose credit score is damaged find debt restructuring to be advantageous. But it is necessary to do it in the best possible way otherwise you may end up paying more interest than the originally due over time.
It is quite likely for salaried persons to face a reduction in their income because of pay cuts. A businessman or a professional might see a reduction in their income or suffer losses. The banks or financial institutions allowing loans prefer loan restructuring over a loan becoming a non performing asset. However, the recalculated payment should not become a burden for the client. For this the present value of future payments is worked out. What is the present value? It is an amount of money today that is worth more than the same amount in future. Calculating present value involves assuming that a rate of return could be earned on the funds over the period.
Understanding loans can be made easier if you become familiar with each part of the entire process. There are some important criteria involved while taking loans and also when a debt is paid off. In this article we will try to understand a few relevant ideas revolving mainly around repaying and restructuring debt/loan along with a few loan basics. The topics which are discussed in the below paragraphs will prepare you better before you take any decision pertaining to a fresh loan or an outstanding debt.
How will you evaluate loans?
The first step is to be vigilant enough while taking a loan. You may like to consider a few factors affecting the repayment of the same. These factors have a direct effect on the cost of loan. You may like to look at the following before finalising a loan:
1. The duration of the loan-This depends upon individual preferences. There are people who want a longer duration of the loan and EMI too of a smaller amount. In that case they will end up paying more interest for a prolonged period. The longer the period, the more will be the interest component. Different financial institutions offer different periods of time to repay the loan. You need to do the math while choosing a particular time frame.
2. Cost of borrowing:The loan is processed and a fee is charged for that. It could be charged as a percentage of the loan amount or a fixed sum may be collected. This is over and above the interest amount. In a few cases the processing charges are waived and that could compel a potential borrower to lean towards such loans.
3.The nature of the benchmark: Loans are linked to external benchmarks like the repo rate. The internal bank benchmarks do not change frequently. This could affect the decision about a loan.
Restructuring a loan:
When a decision is made to restructure the repayment of a debt/loan, it can be made either by reduction in the monthly payment/principal/interest amount. Each of them is explained with the help of examples here:
- Reduction in number of monthly instalments-A loan amount of Rs.5 lakh has to be repaid over the next 5 years @ 8% interest rate. The EMI is Rs.10,138 in this case. Suppose the borrower wants to restructure it, and the loan period gets extended to 8 years then the EMI will be of Rs. Rs.7,068. This is known as the present value of the loan amount. (The EMI can be calculated by using the ‘=pmt’ function in MS Excel. There are various loan calculators made available by different sites on the internet as well.)
- Reduction in the principal amount-This is possible when the lender reduces the principal loan amount. Let’s assume in the above example it gets reduced to Rs. 3 lakh. The EMI will come down to Rs.6,083.
- Reduction in interest rate-Suppose the interest rate is reduced to 5%, the EMI will be Rs. 9,436.The period of repayment should remain the same, otherwise it will cost more to the borrower.
Similarly, the duration of loan can be decreased but that should not result in more EMI per month putting more pressure on the borrower and giving no relief in real terms.
Getting an additional loan can also help a borrower in reducing the loan amount. But the new loan should not tie him up by prescribing stricter terms, ultimately making it burdensome. Thus, the present value of the cash flows should be known to the borrower in order to get a correct picture of the outcome.
Repayment schedules with varying interest rates-Repayment of any loan consists of two parts: the principal and the interest amount. Every borrower needs to know how much of the EMI goes towards the repayment of principal. The rest is paid by way of interest. PMT and PPMT functions can be used to bifurcate the outstanding amount in an excel sheet. The IPMT function shows the amount paid as interest. Lenders use ‘rest’ to indicate the interest charging cycle and it can be different from the payment cycle.
Let’s take an example of a loan of Rs. 20 lakh and the interest rate @ 8%. The duration of the loan is 10 years. Assuming that the loan is repaid in monthly instalments, 1 is entered for the first month and calculation is made for 120 months then using the IPMT function the interest amount comes to Rs. 13,333 showing the total breakup of the entire EMI.
PPMT=Rs. 10,933
IPMT=Rs.13,333 and the total EMI=Rs.24,266.
If the interest rate drops to 5% then the total EMI will be Rs.21,213 and the composition will also be different, divided into the principal and interest amount. The principal shall be Rs. Rs.12,880 and interest=Rs. 8333. This is the first instalment showing that the majority is allocated towards repayment of the principal amount.
Contrary to this if the rate of interest goes up to 10% the EMI will rise to Rs. 26,430. Only Rs. 9763 will go towards the repayment of the principal in the first month. The rest Rs.16,667 goes towards the interest part. If the rate of interest increases, more goes towards interest from the first payment.
Change in EMI and change in tenure to due to interest rate changes:
There are fixed and floating rates of interest applicable to loans. Floating rates are more popular as they are benchmark linked and accordingly they keep on changing. Long term loans are mostly preferred with a floating rate of interest. While taking a loan, the tenure of the loan and EMI are known to the borrower because the repayment of loan is set according to the income and savings level of each borrower.
The change in interest rate affects your EMI amount and also your repayment planning or tenure in the case of floating rate of interest. The change in interest will not affect the EMI but the tenure will be adjusted by the lenders. Choose floating rates when you are sure the base rate is going to stay constant or reduce over time. The interest will remain the same or even reduce in this case. You have the option to make prepayments to pay off the loan faster. When you can predict an increase in your future income, this option will be useful. The overall interest charged will also be less. However there is a risk that interest rates might go high due to their link with the benchmark. If the interest rate goes up, the repayment tenure will increase, and if it falls there shall be a reduction in tenure.
As against this, fixed interest rates are preferred when you do not want any changes in the interest rates. Fixed interest bearing loans usually charge higher interest rates. But you can do better financial planning knowing exactly what you are going to pay by keeping the EMI constant. The tenure also remains constant. Market linked risks are kept at bay by choosing this option.
Furthermore, you are free to switch to a floating rate of interest when you are able to perceive that you can save more by opting for it as far as interest outgo is concerned.
Banks can guide in this matter, as they might be able to have a better view of interest rates than an individual borrower. In each case the borrower should be comfortable enough to pay it and be able save for other needs. In case of fixed loans, the banks bear the risk of future rates while in floating rate loans, the borrower has to adjust to the changes.
How to reduce debt faster?
There are borrowers who have taken huge amounts of loans. They want to manage their debt in the quickest possible way by reducing them. The strategies to reduce the debt are discussed here:
- Avalanche- Under this method the paying off of the highest interest bearing loans is done first. The costliest loans are those with a higher rate of interest. So by prioritising their repayment first it will help in reducing the overall interest burden. The loans with lower rates of interest will not affect the overall financial situation much. But if the loans with a higher rate of interest are not of a substantial amount, then this rule will not be of any use and it will not reduce the total interest payment. Let’s understand this method with the help of an example:
An individual has a housing loan of Rs. 30 lakh at 6% rate of interest, personal loan of Rs. 1.5 lakh at 12% rate of interest, a crest card outstanding of Rs. 50,000 at 40% interest rate and a car loan of Rs. 2 lakh at 10% rate of interest then by adopting the avalanche strategy, the credit card dues should be paid first followed by the personal loan, the car loan and then the home loan.
- Snowball-As per this strategy the least amount of debt is paid first. Interest rate is not taken into account. The debt with the highest interest rate might be left out while paying off a smaller loan amount. It focuses on eliminating the debts with smaller amounts giving a sense that only a few loans are remaining. But what if the higher amounts of loan carry a higher interest rate? In that case it will leave the borrower in trouble. Snowball is not an advisable method to reduce outstanding debt/loan. The whole exercise feels like a motivational strategy as the least amount on the list of debts is paid, and the next higher amount becomes due.
- Blizzard-This strategy has the features of both the above mentioned strategies. Using the snowball method, it eliminates the smallest amount of loan first. This feels relieving as the small amounts get cleared off. Then the avalanche method is used. The debt amounts with highest interest rates are paid first. The portfolio becomes light as the highest interest bearing debt is paid off. Considering the example given under the avalanche method, the credit card debt will be paid first as it is the smallest amount of debt. Next will be the personal loan with a high rate of interest followed by the car loan and home loan.
Which option is better- to invest the extra money or pay off an outstanding loan by using it?
If an amount is received by an individual as a one time gain or a lump sum benefit, there arises a question, whether to invest the money thus received or use it to pay off a debt? The conditions affecting this decision are discussed here:
- When there is a high debt burden, the money can be used to pay off a part of it, thereby bringing it to a comfortable level. The amount received to pay off the debt might not be significant enough, but at least it can give some amount of mental peace.
- The amount available to repay the loan or invest should be seen both in absolute as well as relative terms. If the amount is quite high, it should be seen both as a major reduction in the loan amount and also as an alternative way to earn interest by investing the same. Interest paid on loan and received by investing the amount received as a lump sum benefit must be compared. If the amount is able to eliminate the debt itself, then one might choose to be debt free. If the amount is small, it will not make any major difference if at all used to repay the outstanding loan.
- When the amount of debt is something like a credit card carrying an exorbitant rate of interest, repayment will work as a better choice. Repayment of loan would mean EMI with a higher interest component initially is paid and later it will pay more towards the principal. Reverse is the case when you opt for investing the money to earn interest. When it is invested for a longer term, it will become more fruitful. The outcome might be sufficient enough to pay off the outstanding loan if invested wisely due to the benefit of compounding.
- Look at the asset class of the investment. When the money is invested in equity shares there shall be a risk. If the return on investment over a longer period comes to 12% and the rate of interest on loan is 7%, then it is better to invest. But it should be kept in mind that the risk element is always involved. There could be lesser returns from investment in case of market linked investments in times of high volatility of markets. But mostly the investments fetch returns at a compounding rate and are able to take care of the interest component of debt.
Debt Refinancing
A borrower can apply for a new loan or debt instrument having better terms than a previous outstanding debt and which be used to pay off in part or in full the previous obligation. A cheaper loan can be taken to pay off an existing debt. This may work as a quicker way to restructure a loan. But this is possible only when the borrower holds a high credit rating. Because otherwise to get a loan at favourable terms is not possible. Again, this can be done when a new loan is available at a lower rate of interest. For the same nominal loan, the borrowers are allowed to pay lesser interest. Many fixed term loans have call provisions, terms that impose penalties for early payment of loans. At that time the net present value of the cost of one loan against the other needs to be done by the borrower.
Restructuring and credit score
Many banks allowed the restructuring option to borrowers in India because of Covid-19. The borrowers who opted for it did not face any degradation in their credit scores. But in other situations it will definitely impact a borrower’s credit score directly or indirectly. The loan shall be reported as ‘restructured’ in the credit history and will result in lowering the credit score of the borrower. In future if another loan is required, the lender might come up with stricter terms. However, if the borrower is making timely payment of the restructured loan and does not have immediate plans to apply for another loan, he will get enough time to reinstate his credit score.
Loan restructuring will squeeze the borrowing capacity to the extent of the extended time. Unless and until there is a big financial requirement during the extended tenure, the option of restructuring should not be chosen.
How does the process work?
The person seeking the restructuring has to contact the lender and explain his/her financial difficulties. It is better for the borrower to contact the lender than the lender waiting to contact the borrower who becomes a defaulter. The lenders will stick to their terms and are usually not supportive of relaxations in the original repayment schedule. Mostly individual borrowers do not turn out to be defaulters and even if they do, they will regain the financial sources like getting another job etc. to repay the debt. The lender may extend temporary support or loan restructuring. There will be many options and several forms to be filled when you go for a restructuring option. Negotiating with the lender is possible sometimes and one needs to agree with the new terms for the loan and sign the agreement. The new agreement needs to be followed until the debt is fully paid off.
Credit card issuers offer a settlement as those are not term loans. The outstanding can be converted into EMIs and repayment is allowed in two to three instalments. The interest charge too may be waived to a certain extent. The credit card facility however stands closed even after repayment. There are few other ways like liquidating the investments that do not fetch much return and using them to pay off debts. When the interest earned from such investments are lower than the interest payable on loan, it is advisable to liquidate such investments.
Before contacting the lender, a borrower can think about such ways. Debt restructuring can help if there is genuine trouble repaying the loan obligation. Bankruptcy is the last thing for wiping out the eligible unsecured debts.
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Bhoi Smrutirekha Dharanidhar
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