Falling behind with debt is a huge roadblock to financial freedom. It is hard to comprehend just how expensive debt can be.
When you service your credit card debt of around 24% annualized, be extremely mindful of the fact that this debt costs you a lot more than you can ever earn elsewhere. Even if you are servicing a much cheaper loan – say 12% per annum, once you clear it there is an immediate return there.
Mind you, that is just the financial repercussion. It also has a huge emotional cost and steals you of your peace.
When you accumulate debt, you operate on numerous assumptions.
- You shall be earning much more in the future.
- You will never be unemployed.
- Not only will you clear your debt but even stack up on your savings that have lagged.
- You will have sufficient funds in your retirement kitty to help you maintain your lifestyle.
I am reminded of a quote by Bryan Davis: Assumptions are unopened windows that foolish birds fly into, and their broken bodies are evidence gathered too late.
Debt grows faster than anticipated. It takes longer to pay off. It cripples your ability to save. You could jeopardize your entire retirement if you don’t get ahead of it. Getting rid of debt should be a priority.
Here’s how to crawl out from under a mountain of debt.
Take inventory of all debt. Make a list of everything you owe. Credit card debt, personal loans, education loans, vehicle loans and home improvement loans. What you can keep away from this list is a home loan since the tenure could span over a decade.
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 are in a position to decide which route to take.
Debt Avalanche Strategy
This is when you pay off your debts in order from the highest interest rate to the lowest, regardless of balance.
Say you have a credit card outstanding bill of Rs 40,000 at 24% per annum interest rate. But your personal loan is 18% per annum. This strategy would need you to pay off your credit card bill with priority as it has a higher cost.
But 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 channelized into the one with the highest interest rate. Once you clear that, you move on to the next most expensive outstanding.
Debt Snowball Strategy
This time, the size of the debt becomes the focal point, not the cost of it. Make the minimum payment on each loan, while the extra money you have managed to save should be channelized towards clearing the smallest debt. Once that is paid off, you move to the next one, and the next, until you are debt-free.
If you have many loans, this is a good way to clear the clutter.
As with everything to do with money, there is always a story behind the numbers.
You can’t tackle debt devoid of a plan. You need to be very intentional about being debt free. And both strategies help build momentum. The one you choose is completely dependent on your mental makeup.
This is important because understanding the psychological aspect of each strategy can make the difference between sticking with the plan and stopping.
Let’s see what Morningstar’s experts have to say on the subject.
- Leon Zeng
- Morningstar's director of behavioural insights
Financially and theoretically, it is always better to pay off the highest-interest-rate debt first (Debt Avalanche), because reducing the total amount of interest-paying liability would benefit the investor from the mathematical perspective when considering the total payment to clear the debt.
In reality, many consumers try to pay off the smallest debt first to get a sense of control, further a sense of achievement, and even more practically, to stop repeated collection calls from creditors to get peace of mind.
- Christine Benz
- Morningstar's director of personal finance
If a strategy incentivizes someone to become debt-free, it's hard to be a naysayer!
With the Avalanche Strategy, you’re wiping out high-rate debt first; such debt is the costliest for you. The math favours this avalanche approach, but if the Snowball Strategy helps someone actually achieve the goal of being debt-free, there's value in that, too.
Anyone who has ever tried to tackle a daunting task--whether cleaning up a house after a dinner party 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.
Nothing is written in stone
Figuring out the right strategy is completely dependent on you and your mindset. You need to narrow down on what drives you.
Pay-the-smallest-debt-first is a straightforward strategy that can provide you with the much-needed motivation you need to get started. The small win can help you stay on track.
But it also means that getting rid of the smallest debt entails holding onto the debt with the highest interest rate longer. This translates into paying more in interest.
If that irks you, then the Avalanche Strategy is your cup of tea.
Or, you can try a combination. 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.
Investment Involves Risk of Loss.
