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Debt Management: Steps To Get Out of Debt and Become Debt-Free



Having debt keeps you worried for various reasons. We constantly worry about the next paycheck, an interest rate hike by RBI, rising living expenses, etc.


Imagine for a moment, you become debt-free, and life would be much simpler and peaceful. Becoming debt-free early on will give you the financial freedom to invest in your future as well.


In this blog, we look at the various options available to consumers to pay off debt sooner.


Importance of a sound financial plan


A sound financial plan is the foundation towards financial freedom. Whether you want to retire early, build an emergency fund, or become debt-free, there should be a plan.


To quantify your plan, you need to understand what is your income, and expenses and how much you can set aside to achieve your goal(s). Additionally, there should be a fund for emergencies.


Importance of Budgeting and Emergency Fund


We have already discussed the art of budgeting in detail here.


Then comes the emergency fund.


An emergency fund is a saving or reserve you set aside to help you cope with emergencies or unexpected events in your life like a job loss, unplanned medical expense, urgent house maintenance, etc.


Having a rainy day fund prevents you from falling into unwanted debt whenever an emergency crops up. At least 6 months of monthly expenses should be saved as an emergency fund in safe instruments like bank deposits or liquid mutual funds.


Now that we have discussed the habits for financial hygiene, let us discuss in detail some methods to pay off debt faster.


Methods to pay off debt faster

1. Avalanche method - In this method, you try to pay off the loan with the highest interest rate.


First list out all your debts. From your salary, allocate the minimum EMI for all your loans. Then allocate an amount from your budget to make additional payments to the loan with the highest interest rate. Let us look at an example below


Budget items

Amount (Rs)

Monthly salary

80000

EMI

​30000

Utility (Electricity & Water)

​1000

​WIFI, Phone recharge

​1000

​Grocery

​7000

​Petrol

​2000

​Gas

​1000

​Medical Expenses

​1500

Child Expenses

​2500

​Travel expenses

​1000

​Miscellaneous

3000

Total Monthly Expenses

50000

​Allocation for emergency fund

​10000

​Investing

​15000

Balance

5000

In the example above, EMI towards all loans are allocated. After considering the monthly expenses, emergency fund and investments, the balance amounts to Rs. 5000. Thus, Rs. 5000 can be paid as additional payment towards the high-interest loan.


Once, the loan with the highest interest is paid off, focus on the one with higher interest among the remaining loans.


2. Debt Snowball Method - Of course, any expert would say the avalanche method is the most logical way to pay off your debts. Because you are getting rid of the debt with the higher interest rate first. But, humans are more emotional than logical beings.

  • Suppose the loan with the highest interest rate has the maximum outstanding as well. It will take considerable time to pay off that debt. On the way, you might lose motivation.

  • We might get some motivation by successfully paying off debt even though the outstanding is small

  • Some of us might face difficulty managing a number of debt repayments and would want to reduce the number of loans to make debt management easier.

  • We might be enjoying tax benefits on certain loans like home loans, education loans, etc. Continuing to pay off these loans would be beneficial in the longer run in terms of tax savings.

In the Debt Snowball Method, you pay off the debt with the lowest outstanding first and then start paying off the next lowest debt amount.


Let us understand this using a hypothetical example. Assume the below are the loans in your portfolio.


Loan type

Amount

Interest Rate

EMI

Tenure (months)

Housing Loan

​4000000

​8.50%


​₹ 34,713

240

Education Loan

500000

9.50%

​₹ 5,221

​180

Vehicle Loan

​400000

​8.80%

​₹ 8,265

​60

Personal Loan

​600000

​11%

​₹ 13,045

​60

Here, the lowest outstanding debt is the Vehicle loan even though the Personal Loan charges a higher interest rate.


In the budget, allocate for all the EMIs of your different loans. Then, using the amount allocated in the monthly budget, start paying off the smallest loan in terms of value, here it is the Vehicle Loan. Once it is paid off, start paying off the next smallest loan by using the allocated amount in the budget.


3.Make additional payments


You must have heard multiple times about the power of compounding. In an SIP, if you make an extra Rs. 1000 over a period of 10 years, the impact will be huge. Similarly, if you manage to make additional payments into your loan over your EMI, it makes a similar impact. Your loan can be repaid in a shorter time period.


To drive home this point, see the example below.


Consider a loan of Rs. 50,00,000 at a rate of interest of 7.5% and a repayment period of 240 months.

The monthly EMI is Rs. 45000.


Loan Value

​5000000

Period

​240

Rate of Interest

​7.5%

Now, what if an additional Rs. 5000 is paid, ie. in total Rs. 50,000. The loan will be paid off in 186 months. Similarly, with each additional Rs. 5000, the time taken to repay falls considerably. And, if you are able to pay Rs. 80000 every month, then the loan will be repaid in just 85 months!



EMI

​45000

​50000

​55000

​60000

​65000

​70000

​75000

​80000

Months

240

186

153

131

​115

​103

​93

​85

4.Auto debit or Standing Instruction


Pick a date to make the EMI payments and ensure to schedule a standing instruction to debit the amount automatically from your account every month on the specific date. The advantage of this method is 2 prone.


One, you will not have to manually do the account transfer which involve too many complications. You need to keep a reminder for the transfer otherwise you would forget it. Then you need to manually do the account transfer. This would involve more than 1 bank mostly and the bank servers need to function at the time of transfer. It would also involve too many OTPs. You would spend considerable time making the transactions.


Second, suppose making the transfer becomes a decision you need to make. Let us assume you have already prepaid a part of the loan. It wouldn’t hurt if you do not make the payment this month. Instead of paying the EMI, you are planning to buy the new iphone. Trust me, it would become a habit. There will be so many months with needs cropping up and you eventually ignore making the EMI payments.



So, to avoid the hassles of multiple transactions and to prevent delaying the EMIs, it is best to schedule the auto debit from your savings account to the loan account.


5.Debt consolidation


As discussed throughout the blog, managing multiple EMIs to various loan accounts is cumbersome. Even if you manage to schedule an auto debit, you need to occasionally take stock of the accounts. This can be done by logging into individual accounts and verifying the EMI payments and taking note of revisions in interests.


Instead of making so many EMI payments, consolidate multiple loans to a single one. You can consolidate all your loans into a single loan. Typically, the new loan would pay off the existing debts and you need to make a single EMI repayment. There are many lenders, NBFCs and fintech lenders in the debt consolidation space who can offer competitive rates.


Debt consolidation can offer lower interest rates and longer tenure (lower EMIs) if your request is accepted. The lenders would accept your application depending on your CIBIL score, payment history, income proof, collateral, etc. Also, as one of the conditions of the debt consolidation, there would be restrictions for availing new loans.


6.Loan takeover


Suppose you have a loan with a particular lender. And you found out another lender is offering the same loan at a lower interest rate. You can explore the option of a loan takeover from the existing lender to the new lender.


Loan takeovers are possible for a variety of loans like home loans, personal loans, education loans, vehicle loans, credit card loans, loan against property, etc. The new lender might also give you an option for a top up facility, ie. additional credit at lower rates. This might come handy if you are in urgent need of funds.


While considering this option, one need to go through the fine print of both lenders. You will have to be certain about foreclosure charges, charges involved with the new lender, etc.

And finally,

Once you have successfully paid off the loan continue to do the financial hygiene steps – Budgeting and Maintaining an Emergency Fund. This would help you in the financial planning journey.


Final thoughts

Becoming debt-free is an important step in your journey towards financial freedom. By adopting one or more of the options mentioned in the blog, one can start making early debt repayments. Keep in mind, maintaining financial hygiene and a definite plan are key to becoming debt fee.








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