One of the biggest misconceptions about money is that it is all math. Nothing could be further from the truth. We each have our own relationship with money, and it has an emotional aspect, too.
Now, let’s extend this to debt. Yes, the math needs to work out when it comes to debt repayment. But we will keep hitting against a brick wall if we do not face the emotional aspect of that debt.
The word debt itself is emotionally charged and evokes anxiety or even guilt. Debt increases stress levels. It also keeps you emotionally obligated to individuals whom you are financially indebted to.
Debt has a huge financial cost, too. When you service your credit card debt of around 24 per cent annualised, be mindful of the fact that it can costs you a lot more than you can ever earn elsewhere. Even if you are servicing a much cheaper loan, say 12 per cent per annum, once you clear it, there is an immediate return there.
As you spend precious money servicing your loans, your savings take a massive hit. Your inability to save is a huge roadblock to financial freedom.
Get Ready Psychologically
Don’t Live In Denial: Keeping it a secret will not help. Come clean to your family, spouse or friend. Talk to at least one person whom you trust. Not only will 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, or even emergencies. But now it is overwhelming. You may even be ashamed. But once you identify the emotion, it becomes easier to deal with it. You can now control the narrative and be ready to take the bull by its horns.
Change The Narrative: If you believe that you are doomed and will never be able to get out of this mess, then that is exactly what will happen. Once you become a victim of such a thought process, you will never have the motivation to get out of it. What you think, will become your reality. Reframe your thoughts and get singularly focused on getting out of debt.
Identify Loopholes: This will give you a sense of control. Are you an impulsive spender? Do you order food all the time? Are you hooked onto online shopping sites? Do you eat out a lot? Do you spend a lot of time in coffee shops? Identifying certain habits or behaviour patterns will help you curb your spending, at least till you get your debt repaid. These small changes will build up momentum, give you a sense of assurance, and combined with the strategies I will mention later, will get you on a debt-free path.
Take Inventory: Make a list of everything you owe. Credit card debt, personal, education, vehicle, home and home improvement loans, etc., 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 will be in a position to decide which route to take.
Repayment Strategies
Identify Cheaper Debt: If the interest rate on your credit card is destroying you with rates of 36-42 per cent per year, look for cheaper avenues. You could get a personal loan at a cheaper rate. With that money, you can clear your credit card debt and service the less costly 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 can lower the pressure on your interest payments.
Identify Assets You Can Sell: In a bull market, you could sell some equity. Or, if you have a fixed deposit, you could liquidate it to clear your debt. However, selling assets must only be done taking into account your overall financial situation, the number of dependents you have, and whether or not you have an emergency fund in place.
Having looked at the above factors, there are two repayment strategies. But in both, an exception to the list can be the home loan as it runs into decades and has a significant tax break associated with it. The two options are:
Debt Avalanche Strategy: The focal point here is 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 an outstanding credit card bill of `40,000 at 24 per cent per annum interest rate, but your personal loan is 18 per cent per annum. This strategy would need you to pay off your credit card bill with priority, as it has a higher cost.
Debt Snowball Strategy: The focal point here is the size of the debt, not the cost. If you have many loans, this is a good way to clear the clutter.
In both strategies, 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 channelised into the one with the highest interest rate (depending on which strategy you have opted for). Once you clear that, you move on to the next, and the next, until you are debt free.
Both strategies will help you get on track and build momentum. But the one you choose is completely dependent on your mental make-up.
Logically, it is better to pay off the debt with the highest interest rate (Debt Avalanche). Get rid of the costliest debt, as reducing the total amount of interest-paying liability would benefit you from the mathematical perspective when considering the total payment required to clear the debt.
That would make sense financially and theoretically, but the psychological aspect can make or break the plan.
You could 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. Anyone who has ever tried to tackle a daunting task—whether it’s cleaning up a house 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.
Remember that no single method is sacrosanct. You can try different combinations too. 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 depends entirely on you. 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.
The author is an Investment Specialist at Morningstar India