Time to focus and reduce the debt mess
As the year draws to a close, it is time to take stock of what you did right with your finances in the year gone by and what you did wrong. One of the critical aspects is how you dealt with debt in the year gone by. Were you prudent and focused on repaying debt that you had already taken on, or did you add to it? As you plan for the new year, it is essential for you to have clarity about your debt obligations. Spring clean your debt, albeit a little early, so that you know where you stand. It will define the way you are able to save and invest for your future needs.
Organise your debt
List your outstanding debt so that you know what your obligations are. If you have paid off a debt or reduced your obligations, then it can be a big motivator to continue the good work in the new year.
“Take stock of all loans. Understand why a loan was taken. Was it convenience of payment, such as for electronics; was it taken to create tax efficiency, for instance, a home loan; to create an advantage through employee programmes, such as a car loan or car lease through the employer; or was it taken for a reason that is a combination of any of the above,” said Amit Kukreja, a certified financial planner, and founder, WealthBeing Advisors. Based on this assessment, you can choose to either continue or foreclose the loan. Calculate your monthly debt repayment obligations relative to your monthly income to understand how secure your financial position is. Include all repayment obligations, whether mortgage payments, auto and consumer loan equated monthly instalments (EMIs), or minimum due on credit cards. Lower the ratio, better is your financial security. If this ratio is high, then it is a trigger for you to tighten your budget and get your outstanding debt under control.
Once you know what you owe, the next step is to find ways to repay the debt as soon as possible. If you don’t already have a budget, this is a good time to make a workable one. Take control of your expenses and make it a resolution for the new year. If you already have a budget, then use this time to update it.
If you have any additional source of money, say, a pay rise or lump sum bonus payment, use at least some of it, if not all, to reduce debt. “Use the money to pre-pay the loans where you can do so without having to pay a penalty, such as in a home loan. This will bring down your debt considerably and lower the monthly expenses,” said Aparna Ramachandra, founder director, Rectifycredit.com, a credit consultancy.
Don’t aim to just make the minimum payments due. Remember, the interest payments are a cost. The sooner you pay down the loan, the lesser cost you have to bear. Therefore, save enough out of your income to be able to pre-pay some portion of the outstanding loans too. “You should decide that every time you get a lump sum, a certain portion, say, 20%, will religiously be put aside for debt repayment. This will also ensure that you don’t fritter it away on impulsive expenditure,” said Lovaii Navlakhi, a certified financial planner and founder and chief executive officer of International Money Matters Pvt. Ltd. “If you have a debt that is being used to buy an asset, and you depend on your income to repay (say, the home loan for the house you are living in), make sure you have life insurance of adequate value to cover the debt,” said Navlakhi.
Prioritise to control
Rank the debt so that you know which debt gets priority in repayment and pre-payment. You can prioritise on the basis of importance of the debt to your overall financial situation, the cost of the debt, or the amount of debt outstanding. When it comes to paying monthly obligations, secured debt such as home loans and auto loans should get priority. “If you have multiple debts, try and bring down the one with the highest interest rate, such as an outstanding credit card bill, which has interest rate of around 24-45%,” said Ramachandra.
Lower cost of borrowing
Use this time to see if you can manage your debt better. Explore opportunities for reducing interest costs. You may be able to refinance your mortgage and other loans for lower rates which not only reduces your, monthly EMI but you can use the money saved to pay off other high-cost loans.
Many people who have outstanding payments, start avoiding phone calls from the loan provider. A better way of dealing with the situation is to speak to your loan provider. “You can bring down your cost of borrowing by negotiating with the loan provider, by refinancing if there are options available and through part-payment if money is available. A part-payment will reduce the term of outstanding loan and, hence, the interest cost,” said Kukreja.
Your credit card balances can be transferred to one with lower interest costs and penalties. But consider the fees and costs associated with refinancing before you make the decision. It may be that while the interest rate of the newer loan is lower, processing charges of the two lenders nullifies this advantage.
Check your credit score
All experts advise to do at least an annual check of your credit report to make sure that there are no errors or oversights in it. If you find the records not correctly updated on repayment and closure of loans, or if it mentions loans and credit cards that you have not taken, or if there are errors in personal information, then dispute it and get it corrected. Incorrect data may be dragging your score down. A low credit score will lead to higher costs of borrowing.
Keeping the credit report updated will ensure that there are no delays when you urgently need a loan or credit facility. “The credit rating from CIBIL (Credit Information Bureau Ltd) determines the rate of interest as well as willingness among borrowers to fund you. Checking the score once a year should be the norm, or just before you are considering borrowing,” said Navlakhi.
Use the annual review to organise the documents related to taking and paying debt. Some loan repayments, like home loans, are eligible for tax benefits and you need the documents at the time of filing your tax returns.
Keep debt within manageable levels, always keeping your income and investment needs in mind. Knowing where you stand is the first step of gaining control of debt and spending habits.