Debt is expensive.
It increases stress levels and anxiety. It keeps you emotionally obligated to individuals whom you are financially indebted to. And, it has a huge financial cost.
When you service your credit card debt of around 24% annualized, be extremely mindful of the fact that this debt costs you a lot more than you can ever earn elsewhere. Even if you are servicing a much cheaper loan – say 12% per annum, once you clear it there is an immediate return there. As Morningstar's director of personal finance Christine Benz points out that debt paydown offers a guaranteed return on investment equivalent to whatever your interest rate is.
As you spend precious money servicing your loans, it is your savings that are taking a massive hit. Crippling your ability to save is a huge roadblock to financial freedom.
#Step I: Control the narrative that plays in your mind.
Don’t live in denial. Come clean about it to your immediate family or spouse or close friend. Talk to at least one person whom you trust. Not only does it help when you share the emotional load, but a discussion can also put things into perspective.
Own your mess. Yes, you did use it to obtain certain assets or for frivolous spending, and it is overwhelming. You may even be ashamed. Once you identify the emotion and name it, it becomes easier to deal with. Now you are ready to take the bulls by its horns.
Take inventory. Make a list of everything you owe. Credit card debt, personal loans, education loans, vehicle loans, home loan, home improvement loans, loans from family or friends. In an excel sheet, list them in order of interest rate, and size (amount of outstanding). Once you stack your debt on both parameters, you are in a position to decide which route to take.
#Step II: Look for solutions.
Identify loopholes. You need to up your savings game. So identify certain habits that will help you deal with this, at least till you clear a significant portion of your debt. Are you an emotional spender? Do you order in all the time? Are you hooked onto online shopping sites? Narrow down on certain behaviour patterns that you need to control.
Identify cheaper debt. If the interest rate of your credit card is destroying you with rates between 36% and 42% per year, look for cheaper avenues. You could get a personal loan at a cheaper rate. With that money, clear your credit card debt and service the less costlier loan. If you have a home loan, approach your bank for a top-up loan, which should be cheaper than the credit card debt. This way you lower the pressure on interest payments.
Identify assets you can sell. If you have a fixed deposit, you could break it to clear your debt. However, this must only be done taking into account your overall financial situation, and whether or not you have many dependents, and an Emergency Fund in place. Alternatively, in a raging bull market, you could sell some investments to get debt out of the way.
#Step III: Have a strategy.
Debt Avalanche Strategy: Focal point being the interest rate.
This is when you pay off your debts in order from the highest interest rate to the lowest, regardless of balance.
Say you have a credit card outstanding bill of Rs 40,000 at 24% per annum interest rate. But your personal loan is 18% per annum. This strategy would need you to pay off your credit card bill with priority as it has a higher cost.
But it does not imply paying off one loan to the exclusion of another. Make the minimum payment on each loan, while the extra money you have managed to save should be channelized into the one with the highest interest rate. Once you clear that, you move on to the next most expensive outstanding.
Debt Snowball Strategy: Focal point being the size of the debt.
This time, size of the debt is the issue, not the cost of it. Make the minimum payment on each loan, while the extra money you have managed to save should be channelized towards clearing the smallest debt. Once that is paid off, you move to the next one, and the next, until you are debt-free.
If you have many loans, this is a good way to clear the clutter.
(In both the strategies, an exception to the list could be the home loan as it runs into decades and has a significant tax break associated with it.)
Making the right choice.
Both strategies will help you get on track and build momentum. The one you choose is completely dependent on your mental makeup.
Financially and theoretically, it is always better to pay off the highest-interest-rate debt first (Debt Avalanche). Get rid of the costliest debt because reducing the total amount of interest-paying liability would benefit the investor from the mathematical perspective when considering the total payment to clear the debt.
While the Debt Avalanche strategy makes sense financially and theoretically, what about psychological? This factor can make or break the plan.
You may be desperate to get some feeling of control. In that case, paying off the smallest debt first will help you get that sense of achievement. As Christine Benz says, anyone who has ever tried to tackle a daunting task--whether cleaning up a house after a dinner party or tackling a large project at work--knows that there's great power in just taking those first small steps. The Snowball Strategy is kind of a behavioural trick, the idea being that taking small steps can lead to a sense of motivation and empowerment.
Nothing is written in stone. You can try a combination. If you are really saddled with debt, you can work at eliminating the smallest loan first to keep you motivated. After getting one or two out of the way, you can switch to tackling the most expensive debt. A word of caution here: Have a written plan that you adhere to. Or else you will be switching between the two constantly and not make much progress. Figuring out the right strategy is completely dependent on you and your mindset. You need to narrow down on what drives you.
If you are really overwhelmed and this advice does not help, then seek the services of a professional financial planner.
Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.
