Debt is Expensive.
Increases stress and anxiety levels. It keeps you emotionally tied to the people you owe financially to. And it comes with huge financial costs.
When paying off your credit card debt of about 24% on an annual basis, keep in mind that this debt will cost you much more than you could earn elsewhere. Even if you take out a much cheaper loan, say 12% per annum, once you pay it off, there is an immediate return. As Morningstar’s Personal Finance Director Christine Benz points out, paying off debt offers a guaranteed return on investment equal to your interest rate.
While you spend precious money servicing your loans, it’s your savings that take a big hit. Paralyzing your ability to save is a major obstacle to financial freedom.
#Step I: Master the story that plays in your head.
Don’t live in denial. Talk honestly with your immediate family, spouse, or close friend. Talk to at least one person you trust. It not only helps if you share the emotional charge, a conversation can also put things into perspective.
Own your junk. Yes, you’ve used it to acquire certain assets or for frivolous expenses, and it’s overwhelming. You may even feel ashamed. Once you identify and name the emotion, it becomes easier to deal with it. Now you are ready to take the bulls by their horns.
Make an inventory. Make a list of everything you owe. Credit card debt, personal loans, education loans, car loans, home loans, home improvement loans, loans from family or friends. Write them down on an Excel sheet in order of interest rate and size (amount outstanding). Once you’ve built up your debt in both parameters, you can decide which route to take.
#Step II: Look for solutions.
Identify the gaps. You need to improve your savings game. So identify certain habits that will help you deal with this, at least until you’ve eliminated a significant portion of your debt. Are you an emotional spender? Do you ask all the time? Are you addicted to online shopping sites? Limit certain behavioral patterns that you need to control.
Identify the cheapest debt. If the interest on your credit card is wrecking you with rates between 36% and 42% per year, look for cheaper avenues. You can then take out a personal loan at a lower rate. With that money, you can pay off your credit card debt and pay off the cheapest loan. If you have a home loan, contact your bank for an additional loan, which should be cheaper than credit card debt. In this way, it reduces the pressure on paying interest.
Identify the assets you can sell. If you have a fixed deposit, you can break it to pay off your debt. However, this should only be done with your overall financial situation in mind, and whether or not you have many dependents, and an established Emergency Fund. Alternatively, in a raging bull market, you can sell some investments to get rid of debt.
#Step III: Have a strategy.
Debt Avalanche Strategy — The focal point is interest rates.
This is when you pay off your debts in order from highest to lowest interest, regardless of the balance.
Suppose you have an outstanding credit card account of Rs 40,000 at an annual interest rate of 24%. But his personal loan is 18% per annum. This strategy requires you to pre-pay your credit card bill as it will incur higher fees.
But it does not mean that you cancel one loan to the exclusion of another. Pay the minimum payment on each loan, while the extra money you have saved should be funneled to the one with the highest interest. Once you’ve cleared it up, move on to the next most expensive slope.
Debt snowball strategy: Central to this is the size of the debt.
This time, the problem is the size of the debt, not its cost. Make the minimum payment on each loan, while the extra money you have saved should be used to pay off the smallest debt. Once it’s paid, move on to the next and the next, until you’re debt free.
If you have a lot of loans, this is a good way to clean up the mess.
(In both strategies, an exception to the list may be the mortgage loan, as it lasts for decades and carries a significant tax exemption.)
Make the right decision.
Both strategies will help you get on track and build momentum. Which one you choose depends entirely on your mental makeup.
Financially and theoretically, it is always better to first pay off the debt with the highest interest (Debt Avalanche). Get rid of the most expensive debt because reducing the total amount of liability that pays interest would benefit the investor from a mathematical perspective when considering full payment to pay off the debt.
While the Debt Avalanche strategy makes sense financially and theoretically, what about psychologically? This factor can make or break the plan.
Perhaps you are desperate for a sense of control. In that case, paying off the smallest debt will help you get that sense of accomplishment. As Christine Benz says, anyone who’s ever tried to tackle an overwhelming task, whether it’s cleaning a house after dinner or tackling a big project at work, knows there’s great power in putting those first small steps. The snowball strategy is a kind of behavioral trick, the idea is that taking small steps can lead to a sense of motivation and empowerment.
Nothing is set in stone. You can try a combination. If you’re really burdened with debt, you can work on taking out the smallest loan first to keep you motivated. After eliminating one or two, you can move on to tackle the most expensive debt. A word of warning: have a written plan that you stick to. Otherwise you will be constantly switching between the two and not making much progress. Determining the right strategy is entirely up to you and your mindset. You have to limit yourself to what drives you.
If you are really overwhelmed and this advice does not help you, enlist the help of a professional financial planner.