Borrowers who opted for the loan default must be very concerned as the RBI-mandated relief program ends this month. The prospect of losing EMIs and lowering credit ratings is giving them sleepless nights. Debt and stress are partners for life. Even in normal times, the burden of debt causes distress, ranging from mild discomfort for the financially comfortable to overwhelming anxiety and fear for those with unstable finances. COVID-19 has added a new dimension by adding pay cuts and job losses to the mix – quite debilitating!
Tips on how to win freedom from debt
The mixed use of debt
Debt can be both good and bad. Good debt should be accepted because it uses future income to build assets and helps build a credit history. However, bad debts should be avoided, like the pandemic, because they rob the future and misallocate valuable resources to unproductive expenses. A high level of debt pushes a person into long-term financial difficulties.
Good or bad, the best debt is the one that is paid comfortably and as soon as possible. There are obvious benefits to running a loan. The longer you continue, the greater the interest generated. Investments build wealth for you; debt burdens you with interest.
In the current situation, where equity markets are nervous and fixed-income options offer low returns, prepaying outstanding loans appears to be the best use of funds. Bank deposits are relatively safer, but after-tax returns cannot outweigh the savings from paying off an outstanding loan. Keep in mind that a penny saved is a penny earned. For an 8.5 percent loan, every Rs 1 lakh you pay in advance saves Rs 8,500 in interest. If the interest rate is 12 percent, for every Rs 50,000 prepaid, you can “earn” Rs 6,000 by saving on interest.
There are two general strategies for getting rid of outstanding debt: the avalanche technique and the snowball method. They both have the same underlying goal: to achieve debt freedom as soon as possible. It is a great feeling that reassures the individual. Let’s examine the two methods in detail.
Triggering an avalanche of debt
This method repays the debt by attacking the most expensive loan first. Start by making a list of all your debts. List all loans, including outstanding credit card, auto, personal, education, and home loans. Even loans from friends and family should be on the list.
Next, rank these loans based on the interest rates they charge. Typically, credit card debt is the most expensive loan, charging an annualized interest of 36 to 48 percent. Paying the outstanding credit card should be everyone’s top priority. Then come other unsecured debt, such as personal loans and travel loans, followed by car loans and asset loans. At the bottom of the pile are tax-advantaged loans, such as education loans and home loans. These loans have a very low effective interest rate due to the tax benefits that the borrower gets on the interest paid. For example, if a person in the highest tax bracket of 30 percent takes out an 8.5 percent mortgage loan and claims the interest paid deduction, the effective interest rate is less than 6 percent.
Make a pay snowball
The avalanche method eliminates high-cost debt as quickly as possible. But although it has an eminent mathematical sense, the snowball method has a greater impact on the mindset of the borrower. The snowball method ranks loans in order of size and attacks the smallest loan first before moving on to the next debt.
This method may not be financially sound, but it tends to click a lot of borrowers. It is very encouraging for the borrower to see a loan repaid in full. The sense of accomplishment tends to motivate her to save more. As the snowball accelerates, all loans are paid off.
However, there can be problems because some loans come with foreclosure penalties. Be aware of the fees that will be imposed when you pay off an auto loan or personal loan before the due date. Also, neither the avalanche nor the snowball will work if you don’t stop piling up more debt. It doesn’t make sense to prepay an 18 percent personal loan when you’ve added more credit card debt that charges 36 percent.
When the economy is in a growth phase, that is, 8 to 10 percent per year, it makes a lot of sense to access debt wisely. However, in a period of decline, it is advisable to aim to be debt free.