When working as a debt counsellor with Abhay Credit Counselling Centre, an initiative by the Bank of India, V.N. Kulkarni advised borrowers who were drowning in debt. There was one thing common among the majority of the cases. The borrowers spent heavily on credit cards and then kept paying the minimum amount due, which is, typically, 5% of the outstanding.
Paying the minimum amount is a sure-shot recipe for financial disaster. “It was one of the key reasons for people to fall in a debt trap," said Kulkarni, who is also a retired banker. Take an example of a cardholder who has ₹2 lakh outstanding and the issuer charges an annual percentage rate or APR of 40%. After five years, the cardholder will still have an outstanding balance of ₹72,958, if the person continues paying the minimum amount due.
As more and more people face a cash crunch due to the impact of the covid-19 pandemic in the country in terms of salary and job cuts, the risk of falling into a debt trap is high. There may be credit card debts or other loans that you took care of with your salary till now, but with a pay or job cut, that’s not possible anymore.
If you finding yourself in trouble, you need to have a plan to manage your debt instead of getting overwhelmed by the situation. You need to take stock of how much debt you have and put in a plan in place to pay it off systematically.
If you choose to pay the minimum amount due on credit cards, hoping to clear it once things get better, you will always be at the risk of default. Instead, evaluate your loans. Rank them by the interest rate and also on the outstanding amount.
Remember that there is no one best strategy for you. It will all depend on what works for you. Here are some of the strategies you can use.
It is a classic strategy that most financial planners and debt counsellors advocate. Under this, you need to rank your debt by the interest rate—highest to the lowest. Dedicate more resources to the debt with the highest interest rate, and pay the minimum to settle other debts. Once the debt with the highest loan is cleared off, move on to the next loan in line.
Typically, the interest rate on credit card debt is the highest—the interest rate charged on them can be as high as 43% a year. You should, therefore, pay of the credit cards dues first.
The next target should be pay off personal and consumer durable loans that have an interest rate of up to 24% a year and then the auto loan (9-12%). Once you pay off one debt, immediately allocate the money freed up to the next pile of debt.
The reason behind paying off the debt with the highest interest rate is simple. “It reduces the interest outgo. Once a person clears the debt with the highest interest rate, he will have more money in hand," said Melvin Joseph, a Sebi-registered investment adviser and founder of Finvin Financial Planners.
If you want to make every rupee count, the avalanche method works the best. To illustrate why paying highest debt first saves in interest outgo, take the example of a cardholder who has ₹1 lakh outstanding. If he is paying ₹5,000 every month and the issuer is charging 3.3% monthly interest rate, it would take 34 months to finish the debt. The total interest outgo will be ₹66,153. On the other hand, a personal loan of the same amount at an interest rate of 18% will have an EMI of ₹4,992 for two years. The total interest outgo will be ₹19,817.
This strategy focuses on the psychology of debt repayment. You would choose the debt that has the lowest outstanding amount first, irrespective of interest rates. Dedicate most of your resources to repay this loan, while paying the minimum due on other loans. This will give you a sense of progress and will keep you motivated to pay up other debt that has piled up. If you have dues on, say, three credit cards, pay off the debt on the card that has the lowest outstanding. If you have a personal loan that has three-four equated monthly instalments (EMIs) remaining, focus on clearing it before other debt. “This strategy also works as it reduces the number of loans that a borrower needs to handle," said Kartik Jhaveri, director, Transcend Consulting (India) Pvt. Ltd, a financial planning firm.
In 2016, Harvard Business Review did research on the best repayment strategy. They found that the snowball method was the best way. People were more motivated to get out of debt not only by concentrating on one account but also by beginning with the smallest. In this strategy, however, the debt with the highest interest rate will keep rising. “Paying off the smallest loan has the benefit of reducing the number of loans. But there is a downside to it. The overall debt would not decrease if the loan with the higher interest rate keeps ballooning. This can lead to a lot of frustration as the borrower realizes that a big part (of the overall debt) is still outstanding," said Arnav Pandya, founder Moneyeduschool, an Ahmedabad-based financial literacy initiative.
Another way to tackle debt is to mix the two strategies to repay your debt. The combination is also called the blizzard method. Start with clearing the smallest dues (snowball) and once you feel motivated, target the card or loan repayment that has the highest interest rate (avalanche). To feel motivated and to clear your dues, keep alternating between the two strategies.
Based on their experiences, some advisers suggest other strategies to tackle debt. “In my experience snowball strategy in reverse, let’s call it reverse snowball method, is better and more effective," said Jhaveri. He added, “Loans with the highest balance also tend to take the largest share of the cash outflow." If you have a car loan of, say, ₹3 lakh, and a personal loan of ₹50,000, finish the car loan first, according to Jhaveri’s suggestion. An auto loan of ₹3 lakh at 9.5% for four years will have an EMI of ₹7,537 and the borrower will pay ₹61,773 as interest. A personal loan of ₹50,000 at 18% interest rate for one year will have an EMI of ₹4,584 and the interest outgo will be ₹5,008.
One more way to get out of debt is by consolidating the outstanding amount from different loans and cards. If you have an ongoing home loan, and there is an additional burden of a car loan, personal loan, or card dues, take a top-up home loan to repay all other dues. “Pre-close all other loans and consolidate debt into one or two loans at the lowest interest rate possible," said Joseph. Along with this, liquidate some of your investments so that your top-up loan is not significant.
While the methods discussed above may be effective, it’s challenging to come out of debt unless the borrower makes lifestyle changes, according to financial planners. They also recommend looking at assets or securities that you can sell and unlock some cash. Further, they suggest postponing non-essential purchases not only while servicing the debt but also as a general habit.
All planners recommend giving up on credit cards entirely once you repay them. Instead, use cash for purchases. When a person uses cash instead of a card, he tends to control the spending. “Be frugal. Once the lockdown is over, avoid unnecessary shopping, eating out or travel plans. Also, keep a record of spending. Once you do this, unnecessary spends will automatically get curtailed," said Pandya.
In an ideal situation, all your EMIs and credit card outstanding should be one-third of your income. If you have a home loan, this may not be possible. But always strive towards reaching this ratio to avoid falling into a debt trap.
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