Prashant Kumar, 29, is a senior manager in a private company. It’s been six years since he began his professional career and he’s done quite well for himself. He owns a car, takes a vacation abroad every year, and parties with his friends every weekend. While he lives the good life, he’s financed his lifestyle through a bunch of loans and credit cards.
Kumar is heading down a tricky road. His vacations and partying are financed by personal loans and credit cards, and he has been paying off his auto loan since the last three years. Over 60% of his come goes off in paying off his debt. Ideally, he should have paid off his auto loan by cutting down on his expenses on his credit cards and personal loans. Both cards and personal loans are unsecured loans and the rates of interest are extremely high. He only makes payments on the minimum amount due on his credit cards. Though Kumar hasn’t missed out on a single payment yet, this could backfire on him in a big way.
Kumar is playing a dangerous game here. Multiple loans, and unsecured ones at that, could affect Kumar’s CIBIL credit rating adversely. Multiple personal loans show that he isn’t very good at managing his finances and he is always in need of money. Credit cards companies will not complain if he only keeps paying the minimum amount due. But as the amount he owes keeps increasing, they will increase pressure on him to pay off the money owed and his credit limit will not increase.
Paying off so many loans from a monthly salary will also impact his debt-to-income ratio in a bad way. Many lenders will consider the debt-to-income ratio when they rate an individual’s ability to pay a loan. The debt-to-income ratio takes into account all your loans and credit cards to your total income. A high ratio could mean that the lenders look at you as a high risk and may deny you future loans.
A good credit profile involves a healthy mix of secured loans and one or a maximum of two unsecured loans. A healthy mix of a loan portfolio in the initial stage of your professional career would include a couple of secured loans like an auto loan and an education loan, with one or two credit cards. Later on in life, the education and auto loans should be completely paid off and the only secured loan should be a home loan. There should be no change in the number of credit cards one owns. Ideally, not more than 40 percent of your salary should go off in paying off your debts. A high rate of unsecured loans would mean that the borrower will find it very difficult when he has to apply for a secured loan like a home loan.
The author is Co-Founder & Director, CreditVidya