One of the biggest misconceptions about money is that it’s all math. Nothing could be further from the truth. We each have our own relationship with money, and all relationships have an emotional aspect.
Now let’s extend that to debt. Yes, the math should work when it comes to debt repayment. But we will continue to hit a brick wall if we don’t face its emotional aspect.
Debt has an emotional charge. The word itself is emotionally charged and evokes anxiety, even guilt. Debt increases stress and anxiety levels. It also keeps you emotionally obligated to the people you are financially indebted to.
Debt also has a huge financial cost. When you’re paying down your credit card debt at around 24% annualized, keep in mind that this debt is costing you a lot more than you could earn elsewhere. Even if you’re running a much cheaper loan – say 12% per annum, once you’ve paid it off there’s an immediate return there.
As you spend precious money paying off your loans, your savings take a hit. Crippling your ability to save is a huge barrier to financial freedom.
PREPARE YOURSELF PSYCHOLOGICALLY
Do not live in denial: Keeping it a secret won’t help. Be honest with your immediate family, spouse or close friend. Tell at least one person you trust. Not only does it help when you share the emotional charge, but a discussion can also put things into perspective.
Own your mess: Yes, you used it to obtain certain assets, or for frivolous expenses, or even emergencies. But now it’s overwhelming. You may even be ashamed. Once you identify the emotion and name it, it becomes easier to manage. You can now control the narrative and are ready to take the bull by the horns.
Change the story: If you believe you are doomed and can never 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 eventually become your reality. Reframe your thoughts and singularly focus on deleveraging.
Identify the flaws: It will give you a sense of control. Are you an emotional spender? Do you order food all the time? Are you addicted to online shopping sites? Do you eat out a lot at restaurants? Do you spend a lot of time in cafes? Identifying certain habits or behaviors will help you reduce your spending, at least until you pay off your debt. These small changes will build momentum, give you a sense of confidence, and combined with the strategies I’ll mention later, will allow you to become debt free.
Take inventory: Make a list of everything you need. Credit card debt, personal loan, college loan, car loan, home loan, home improvement loan, loans from family or friends. In an Excel sheet, list them in order of interest rate and size (outstanding amount). Once you’ve stacked your debt on both metrics, you’ll be in a position to decide which way to go.
REIMBURSEMENT STRATEGIES
Identify the cheapest debt: If the interest rate on your credit card is killing you with rates of 36-42% per annum, look for cheaper solutions. You could get a personal loan at a cheaper rate. With this money, erase your credit card debt and pay off the cheapest loan. If you have a home loan, go to your bank for a top-up loan, which should be cheaper than credit card debt. This way you reduce the pressure on interest payments.
Identify the assets you can sell: In a bull market, you can sell stocks. Or, if you have a fixed deposit, you can liquidate it to settle your debt. However, selling assets should only be done taking into account your overall financial situation, whether or not you have many dependents, and an emergency fund in place.
After considering the above, there are two repayment strategies.
A difficult caveat: In both strategies, an exception to the list could be the home loan, as it lasts for decades and comes with significant tax relief.
Debt avalanche strategy: Here, the focal point is the interest rate
This is when you pay off your debts in order of highest to lowest interest rate, regardless of the balance. Suppose you have an unpaid bill of Rs 40,000 on your credit card at an interest rate of 24% per annum. But, your personal loan is 18% per annum. This strategy would require you to pay your credit card bill first, as it has a higher cost.
Debt Snowball Strategy: Here, the focal point is the size of the debt
This time, it is the size of the debt that is in question, not its cost. If you have many loans, this is a good way to clean up.
In both strategies, it does not involve repaying one loan to the exclusion of another. Make the minimum payment on each loan, while the extra money you’ve managed to save should be funneled to the one with the highest interest rate or the smallest debt (depending on the strategy you’ve chosen). Once you clear that, you move on to the next, and the next, until you are debt free.
THE RIGHT CHOICE DEPENDS ON YOUR MENTAL FITNESS
Both strategies will help get you on the right track and build momentum. But which one you choose depends entirely on your mental makeup.
Logically, it is better to repay the debt with the highest interest rate (Debt Avalanche). Get rid of the most expensive debt, because reducing the total amount of debt to pay interest would benefit the investor mathematically when considering the total payment to clear the debt.
It makes sense financially and theoretically, but the psychological aspect can make or break the plan.
You might be desperate for a sense of control. In this case, paying off the smaller debt first will help you get that sense of accomplishment. Anyone who’s ever tried to tackle a daunting task, whether it’s cleaning a house or tackling a big project at work, knows there’s great power in taking those first small steps. . The snowball strategy is a kind of behavioral trick, the idea being that taking small steps can lead to feelings of motivation and empowerment.
Remember that no method is sacrosanct. You can also try different combinations. If you’re really in debt, you can start by eliminating the smaller loan to stay motivated. After eliminating one or two, you can tackle the most expensive debt. A word of warning here: Have a written plan that you adhere to. Or, you’ll constantly switch between the two and not make much progress.
Finding the right strategy is entirely up to you and your mindset. You must specify what motivates you.
If you’re really overwhelmed and these tips don’t help, seek the services of a professional financial planner.
The author is an investment specialist at Morningstar India
(Disclaimer: Opinions expressed are those of the author and Outlook Money does not necessarily subscribe to it. Outlook Money will not be responsible for any damage caused to any person/organization directly or indirectly.)
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