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A Borrower's Guide to Financial Risk Management
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Disclaimer: This Article is for information purposes only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. The Bank makes no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Article. The information contained in this Article is sourced from empaneled external experts for the benefit of the customers and it does not constitute legal advice from the Bank. The Bank, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein. Tax laws are subject to amendment from time to time. The above information is for general understanding and reference. This is not legal advice or tax advice, and users are advised to consult their tax advisors before making any decision or taking any action.
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Every kind of financial transaction carries some level of risk. When you invest in an asset, for instance, you take on the risk that the value of the asset may not appreciate as you expected it to. And when you spend money on a premium purchase, there is the risk that you may not have sufficient funds to meet a financial emergency in the near future.
A loan of any kind also carries its own risks. There are different kinds of credit facilities and loans that you can avail of today. Some of the most common avenues include home loans, personal loans, credit cards and loans against property. Each of these loans and credit options comes with some kind of financial risk.
If you are a borrower with a sizable debt portfolio, it is essential to know what these risks are and how you can manage them. So, let’s dive right into the heart of the matter and check out how financial risk management for borrowers works.
Here are the top 4 risks to be aware of.
The risk of falling into a debt trap
A debt trap occurs when you take on more debt than your repayment capacity, on account of which you need to borrow more money to repay your existing debt. For instance, let’s say you have a credit card bill of Rs. 1.2 lakhs this month, which you cannot afford to repay. But to avoid high interest costs, you take on a personal loan of Rs. 1 lakh.
Then, after another month, you find it difficult to repay your personal loan EMI, so you borrow some money from a friend. This is how you fall into a debt trap.
Here’s how you can manage this risk:
To avoid falling into a debt trap, here are some measures you can take.
The risk of interest rate changes
When you avail of a loan, you will have to pay it back in instalments via EMIs. Each EMI consists of a part of the principal, which is the original amount you borrowed, and a part of the interest, which is the additional cost you incur for the benefit of repaying the loan in instalments. While most loans come with fixed interest rates, some may have variable rates of interest. Here, the interest rate changes based on the market benchmark, like the repo rate.
The risk with such loans is that if the benchmark rate increases, so do your loan interest rate. This may lead to higher outlays in the future.
Here’s how you can manage this risk:
To manage this risk, you can take the following steps.
The risk of your credit score falling
Your credit score is a number that indicates how reliable you are as a borrower. Typically, this number ranges from 300 to 900 (in case of the CIBIL score), and anything over 750 is a good score. The loans and debts in your portfolio directly affect this number. If you fail to repay any EMIs or pay your credit card after the due date, your credit score takes a hit.
The downside of having a poor credit score is that it becomes increasingly more challenging for you to avail a loan in the future. This is another risk that you face as a borrower.
Here’s how you can manage this risk:
Fortunately, this risk is much easier to manage than the others on this list. Here’s what you can do.
The risk of asset repossession
This risk arises if you have availed of a secured loan, where you need to offer an asset as collateral. For instance, if you avail of a home loan or a loan against property, your house will be the asset offered up as collateral. In case you do not repay your debts on time and you default on the loan, the lender can take possession of the asset you put up as collateral.
This is known as asset repossession, and it is a very real risk if you have taken a secured loan of any kind.
Here’s how you can manage this risk:
The good news is, this risk can also be easily managed and mitigated. Here’s how.
Conclusion
These common financial risks always accompany any kind of debt you may take on. However, with the pointers outlined above, you can get better at financial risk management even if you have a significant portion of debt in your portfolio. When managed well, debts can actually help you create assets and achieve your financial goals sooner. So, be prudent about the kind of debt you take on rather than eliminating it altogether. And focus on improving your financial risk management skills over time.
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