Taking out loans to cover volatile income creates a debt trap for many people

ByRichard C. Sloan

Apr 29, 2022

It is always suggested to avoid taking out loans for consumption or for the purchase of depreciable luxury items. Taking a loan is beneficial when it improves income-generating capacity – such as a loan to build productive capacity or an education loan to improve employability, or to acquire valuable fixed assets that require large investments – like a home loan which also offers the possibility of moving. own home and save on rent payments.

Lack of regular income

However, without having a fixed monthly income, many Indians find no other choice but to borrow as consumption expenditure remains more or less the same even during the months with no or very low income.

“As many Indians do not earn regularly, they end up borrowing dearly,” said Abhinav Nayar, CEO of Mool, adding, “While most Indians may suffer from income volatility, their consumption expenditures are more regular. , which suggests that there is already a smoothing of consumption. However, much of this consumption is driven by indebtedness. In fact, the two main characteristics of Indian household indebtedness are that Indians become increasingly over-leveraged and that informal and inefficient sources of borrowing crowd out cheaply secured institutional debt.

High debt

With very few opportunities for higher income to repay the loan with high interest, the debt burden continues to mount.

“Indian households are sinking deeper and deeper into debt. As a percentage of GDP, household debt has increased from 11.2% to 37.1%, more than tripling, between 2011 and 2021. Mortgages and gold loans, which are used to finance the two assets preferred by Indians, account for only 23% and 8% of household debt, respectively. Greater consumption of services such as education and health, which have become more expensive, could also explain the rise in debt. Notably, however, for the Risers and Aspirers, much of the rest of their debt comes from discretionary consumer spending. The widespread availability and growing demand for no-fee EMIs on durable goods, credit cards and personal loans can be seen in the 13% growth in consumer loan products in the third quarter of 2019. For households low-income (Strivers), credit could be treated as an additional source of income. In 2016-2017, 53% of farming households had an outstanding loan of an average of Rs 1,04,600 which is about 98% of their average annual income,” Nayar said.

High interest rate

To obtain loans on favorable terms, you must have a stable income and a good credit rating. However, with volatile incomes and poor repayment histories, these borrowers lack access to cheaper institutional borrowing and must rely on high-interest loans from lenders.

“Household debt, in itself, is not necessarily a negative characteristic. On the contrary, the effective use of debt could bring great benefits to individuals and, by extension, to society as a whole. One of the biggest problems with Indian household debt, however, is the extent to which it comes from expensive, non-institutional sources. Unsecured debt from pawnbrokers, convenience stores, family and friends accounts for 56% of Indian household debt. Unsecured debt carries exorbitant interest rates as there is no collateral, which compounds the already high cost of capital in India. The median annual interest rate for non-institutional loans (secured and unsecured) is around 25%, and the maximum could be as high as 60%. The extremely high rates and the large gap between the median and the maximum illustrate the potential for exploitation and the pitfalls of leverage. In contrast, institutional secured loans impose interest rates of 12% and 16%, as the median and maximum respectively. Although even these interest rates are high relative to those in developed countries, the amount borrowers could save by replacing unsecured and non-institutional debt with credit from more formal, asset-backed sources is clearly evident. Nayar said.

Institutional credit

While the poor and needy have no or limited access to cheaper institutional credit, wealthier rural households borrow heavily from financial institutions.

“There is evidence that institutional credit already has some traction among important demographic groups, such as rural Strivers. For example, farm households, which are wealthier than their rural non-farm counterparts, currently derive 46% of their debt from commercial banks, illustrating that this is an existing trend that can form the basis of a future growth,” Nayar said.