Make minimum payments on all debts, then use extra funds to tackle the smallest debt first.
As India marked its 78th Independence Day, have you considered what financial freedom means to you?
For many, it's about having savings, investments, cash reserves, a solid retirement fund, and the freedom to pursue their chosen career. However, the first step towards achieving any of this is escaping debt.
"Reducing or eliminating debt frees up funds for goals like a home purchase, children's education, and retirement," says Jinal Mehta, founder, Beyond Learning Finance.
Household debt in India has been rising, reaching a record high of 39.1 per cent of GDP in the third quarter of fiscal year 2024, according to a Motilal Oswal report.
In its June 2024 Financial Stability Report, the Reserve Bank of India had noted that with household savings declining and financial liabilities increasing, household debt warrants close monitoring.
Here are strategies borrowers looking to escape a debt trap can adopt:
Debt settlement
Debt settlement involves negotiating a payment less than the total owed, such as settling a Rs 4 lakh credit card bill for Rs 2.25 lakh. While it might seem like a money-saving option, it has significant drawbacks.
"Stopping payments to seek a settlement can lead to late fees and penalties. This debt also gets marked as 'settled' in your credit report, harming your credit score and future access to credit," says Adhil Shetty, CEO, Bankbazaar.com.
If you choose this strategy, negotiate the settlement amount directly with the lender. If using a third-party firm, ensure they are bank-approved. Obtain a written settlement agreement.
Debt consolidation
Debt consolidation involves taking a new loan, ideally with better terms, to pay off existing debts.
The goal is to reduce the interest burden by replacing high-interest loans with one having a lower rate, or increasing the tenure to lower the EMI.
Shop around. "Don't settle for the lowest EMI or the first interest rate offered, as they may increase total interest cost," says M Barve, founder, MB Wealth Financial Solutions.
Remember, access to new borrowing may be limited until you pay off the consolidated debt.
Debt avalanche
This is the most popular strategy. It involves following the highest-interest-first approach.
Rank your loans by interest rate from highest to lowest, make minimum payments on all to avoid default, and then use any surplus to pre-pay the debt with the highest interest rate.
"The debt avalanche strategy saves the most in interest cost," says Mehta.
If higher-cost debts are your largest borrowings, you will see slower progress initially. It also limits the savings available to the borrower.
Debt snowball
With the debt snowball method, the borrower pays off the smallest debt first and gradually moves towards the largest, regardless of interest rate.
Make minimum payments on all debts, then use extra funds to tackle the smallest debt first. After clearing it, move to the next smallest.
"By providing a quick win in the debt repayment journey, it boosts confidence. However, it is costlier," says Barve. Research shows this strategy works best from a behavioural standpoint.
Borrowers may also combine strategies. Start with the snowball method and pay off the smallest debt first, then use extra funds to tackle the highest-interest debt.
This approach strikes a balance between reducing interest cost and building confidence.
Consider debt consolidation if you have several high-interest debts to manage. Use settlement only as a last resort.
How balance transfer credit card works
Purpose: Consolidates multiple credit card debts into one, reducing financial strain and potentially improving credit score
Interest: They provide lower interest rates, often 0%, and interest-free periods on new purchases if the balance is paid off in time
Advantages: They offer introductory rates and extended interest-free periods, aiding in debt consolidation and reducing financial strain
Avoid: Using balance transfers just to delay payments without curbing expenditure can backfire
Advice: Check the new card's terms, including fees, rates, and the duration of promotional offer; pay off the balance before the offer expires
Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Feature Presentation: Ashish Narsale/Rediff.com
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