Debt trap

The workbook draws a single, very clear line. Debt for an appreciating asset — a house — is fine. Debt for something that raises earning capacity — an education loan to upskill — may even be recommended. Short-term debt to bridge a genuine cash flow mismatch is acceptable, provided the borrower knows the risk and has a plan to repay quickly.

Debt to finance regular expenses is where it stops. Someone who starts borrowing to meet ordinary monthly expenses is living beyond their means and is likely in a debt trap. Nothing about the amount defines the trap; the purpose does.

What turns that line into a spiral is the cost of the debt available to someone in that position. It is the most expensive money in the market.

Secured loans — mortgages, education loans — are relatively cheap, because the lender holds security. Unsecured loans, meaning personal loans and credit card debt, are very expensive and must be used with caution.

A credit card is an interest-free borrowing option only if use stays within the specified limits and the repayment is made in full by the due date each month. The moment some amount is carried over into the following business cycles, it becomes revolving credit. At the 3% a month a card company may charge, the compounded annual cost is (1 + 3%)^12 − 1 = 42.6%. In the unorganised sector — pawn traders, money lenders — rates run as high as 60–80% a year, or 5% a month.

The workbook's way out, in order: rank debts by cost and kill the costliest first; sell the asset the debt bought if it has a reasonable realisable value, allowing for pre-payment charges; refinance expensive debt with cheaper, of which a credit card balance transfer is the example; extend the tenor to cut the monthly outgo, accepting that total interest paid rises; and, failing all of those, tell the lender and negotiate a revised schedule — knowing that rescheduling damages the borrower's credit history and credit score.

A client carries a revolving credit card balance of Rs 3,20,000 at 3% a month.

Effective annual cost = (1.03)^12 − 1 = 42.6%
Interest on Rs 3,20,000 for a year = 3,20,000 × 42.6% = Rs 1,36,320

Rs 1,36,320 a year, and not one rupee of the Rs 3,20,000 has been repaid.

He also holds a fixed deposit of Rs 4,00,000 earning, assume, 7% — Rs 28,000 a year — and does not want to break it. That instinct costs him money, and the comparison makes it obvious:

His full position, with the two loan rates assumed:

The repayment order follows the cost column, not the size column: card, then personal loan, then the home loan last — it is cheap and carries tax benefits, so it waits until finances permit.

And the line itself. If, instead of any of this, he borrows another Rs 3,20,000 to pay this month's school fees and groceries, the arithmetic stops mattering. He has begun borrowing to meet regular expenses. If he does it at a money lender's 5% a month, the interest alone on Rs 3,20,000 is Rs 16,000 every month against a principal that never moves.

Chapter 4 (Debt Management and Loans), sections 4.3.1 to 4.3.4 — purpose of debt, cost of debt, maturity of debt, and debt re-scheduling. The revolving-credit arithmetic is a favourite: 3% a month compounding to 42.6% a year appears verbatim in the workbook and reliably in the paper. Expect also the ordering rule for repayment, and the conceptual question on when borrowing is acceptable and when it marks a debt trap.

• 3% a month is not 36% a year. Compounded it is (1.03)^12 − 1 = 42.6%, and that is the figure the question wants.
• A credit card is interest-free only inside the specified limits and only on full repayment by the due date. Any carry-over is revolving credit at the full rate.
• Repay the costliest debt first, not the largest. Home and education loans are cheap and tax-favoured, so they are dealt with last.
• Extending the tenor cuts the monthly outgo and raises the total interest paid. Both halves of that sentence are examinable, and questions test the second one.
• Rescheduling is not consequence-free — it hurts the borrower's credit history and credit score, which is why it sits last in the list.
• Short-term borrowing to bridge a temporary liquidity problem is not a debt trap, as long as the borrower understands the risk and has a repayment plan.
• Debt is not the villain. Leverage may actually increase the return made on an investment; the workbook cites the Modigliani-Miller argument in the same breath as the warning.