There is an old saying that goes, “Debt is an evil – work towards paying it off so that you can maintain a debt free life, with less money stress.” But Donald Trump says that “I am the King of debt. I do love debt. I love debt. I love playing with it”
Most news articles and stories are centered on the negatives of debt, but in reality, there are plenty of positive aspects of personal debt. After all, very few of us could actually afford to purchase a home or attend college without some sort of assistance through credit. The key is to make debt work for you, and not against you.
There are two kinds of debt. They are classified as BAD DEBT and GOOD DEBT.
In simple words, the bad debt pulls out money from your pocket, while good debt adds money into your pocket. Good debt can be used to buy something that will increase in value, where as bad debt decreases value. Unfortunately, most people are stuck in a spiral of bad debt, which is regularly pulling money out of the pocket. It acts as a hurdle in the advancement in your financial life.
The number one example of good debt is a home mortgage. It is considered as an example of good debt because the house will grow in value in the years ahead in addition to providing you with shelter. Education loans can also be considered as good debt as it helps you earn more money over the course of your working life.
Knowing the difference between good debt and bad debt is a very vast and separate topic, which can be discussed in the other post. For now, we shall discuss about bad debt and ways to overcome it.
Before going further, please answer the following questions in yes or no to find out if your debt is good or bad.
- Has your application for credit card or loan been rejected in the recent past?
- Is your CIBIL score not more than 750?
- Do you have more number of non collateral loans?
- Have you missed the payment of any EMI in the recent past?
- Have you missed any loan repayment deadline in the recent past?
- Have you gotten any calls from your banker asking for restructuring of your loan rather than becoming an NPA and then defaulting
If the answer for anyone of the above questions is “yes”, then you are in the spiral of bad debt and need to urgently pay attention to our Debt Management Plan.
What is a Debt Management Plan?
To put it simply, debt management is the act of managing debts. It can also be referred to as consolidation of your bad debt and majorly unsecured debt into one monthly payment, which is sent directly to your creditors by the credit counseling service.
Key Points to Consider
The basics of debt reduction are simple: Cut down on your variable spending and put the extra money toward your debt payments. But outside of fixed monthly bills such as housing or car payments, you probably don't have a precise idea of how you spend most of your money.
- Make a list of your debt: Make a list of all your debt obligations and the interest you're charged for each. Put them in order of interest rate, from highest to lowest. Or you may even put in the order of huge outstanding amount to lowest.
- Match assets and liabilities: This is a cardinal rule at banks, pension funds and insurance companies. It’s also the idea behind target-date mutual funds, which gradually move from stocks to cash over a period of years when you are saving for college or retirement. The idea is to have assets available at the time you’ll need them. So avoid financing a long-term asset, such as a home, with a short-term loan from a credit card. You can’t use the value of your home to pay the bill. Borrowing long-term for a short-term asset spells trouble too. If you take a 10-year loan for a used car you’ll still be paying long after the car is in the junkyard.
- Track Expenses and Plug the holes: If you want to get your debt under control, start by figuring out your spending patterns and identifying the mandatory expenses. One should be tracking how much money they pay out every month, not only in terms of what they pay to reduce their various debts, but also for everyday and cost-of-living expenses. By doing so, they may be able to identify ways to cut costs for luxuries and other purchases even before making more radical decisions. For one month, write down every rupee you spend. That will clarify how much of your spending is fixed and how much is variable (and hence easier to curb).
- Prioritize Expenses: Save some and spend some. During a credit crunch, the credit you are planning to use may not be available and carrying balances should be avoided. Instead, save for those unexpected expenses and also for regular purchases. Your goal should be to save a minimum of six months of living expenses for emergencies.
- Cut out the extras: Tally the expenses on the list and compare the sum to your monthly income. If it's less than what you earn, use the extra money as your debt payment. If it exceeds your income, you need to cut back on the variables.
- Lower your fixed expenses. Reining in discretionary spending for a few months goes a long way toward tackling debt. But if that's not enough, try to reduce your fixed expenses. Take steps to lower your household bills; refinance your mortgage to get a lower interest rate; or, if you have a good payment history, ask your credit card company to lower the interest rate you're charged.
- Set goals: Set goals and prepare a budget. A plan to keep your spending on track is critical in these economic times. Take some time with your spouse or other key family members and set your short-term and long-term financial goals. Then, put together a budget or spending plan to assure that you reach them.
- Maintain liquid savings: It’s not always possible to perfectly match assets and liabilities. That’s when it becomes tempting to dip into liquid savings. Refinancing your mortgage at a lower rate is a smart move. But you may need to dip into savings to pay out-of-pocket closing costs—a good idea only if you can immediately begin rebuilding your liquid savings. At the same time, stop digging yourself into fresh debt, which can become a grave mistake for life time.
- Cost benefit analysis between Debt Repayment versus Investment: Don’t forget to save. Paying off debt is great. But if you are cutting debt at the expense of socking away retirement savings you will end up disappointed years from now. It may be wise to pay down your debts more slowly and max out savings or investing for retirement, especially if that plan offers an employer match.
- Watch interest rate movements for the rescheduling horizon: If you borrow at a variable interest rate the cost of your loan will rise as market rates go up. That hasn’t been a problem in recent years, as rates have mostly fallen. But the trend will reverse eventually. So plan for higher loan costs down the road
- Transfer high-interest balances: You might consider moving some of your high-interest loans to lower interest rate. But read the fine print carefully and thoroughly before proceeding. Sometimes such low-interest-rate offers are only in effect for short periods of time, after which the rate skyrockets. What's more, consolidating your debt on one card may lower your credit score if your debt-to-available-credit ratio worsens.
- Look for other alternative low cost debt opportunities: The below listed are one to look out for.
- Loan against fixed deposit
- Gold Loans
- Loan against shares or mutual funds
- Loan against insurance policies
- Loan against PPF
- Home equity Loans
- House loan
- Education loan
- Credit card loan
- Personal loan
- Vehicle loan
- Try to boost your income. Consider whether there's any way to boost your take-home pay. If you get an incentive or bonus or big tax refund. Put these to repayment of the high cost or huge debt burdens.
- Read the Terms & Conditions: Before taking out or restructuring any debt, it’s important to understand the terms. Obviously you’ll have to pay back the entire amount plus interest, but beyond that, terms can vary widely. Few terms may be like down payment, interest rates, fixed or variable, processing fees, prepayment charges, late payment charges, insurance costs, and etc
- Pay off the highest rate first: Once you determine the maximum amount you can pay off each month, pay down the debt with the highest interest rate first -- that usually means your credit-card balance -- while paying at least the minimum monthly amount due on all other revolving bills.
- Move down the list: Once the debt with the highest rate is wiped out, put your money toward paying the debt with the next-highest rate. One exception, if you have a credit card with a low teaser rate that will go up after a fixed amount of time, strive to eliminate that balance before the low rate expires.
- Automate bill payments: This may seem odd, but during a credit crunch, creditors are looking to lessen their risk. If you miss a payment, you may find it much more difficult to pay down your balances. Hence switch to automatic bill pay on every account that offers this option. You may even opt for ECS / SIP / Standing Instruction and this will help you avoid the pitfalls of universal default. Choose a bank that assures your payment will arrive on time.
- Check your credit score and reports frequently: Check and dispute errors and any inaccurate information with each lender or credit bureau.
- Never co-sign during that transition period: Being responsible for your own credit use or misuse is hard enough. Never take on the responsibility of paying someone else's credit obligation. This almost never works out. You can easily lose money, credit standing and a friendship.
- Protect your identity: Identity theft is just as real as a thief in the night. It is a growing concern now that credit is more difficult to obtain. The tight credit market increases the motive for people who stoop to the level of stealing your identity to gain access to credit. Remember, most identity theft is done by someone you know. Protect your personal financial information by shredding financial documents and pay your bills electronically.
The Benefits of a Debt Management Plan
- An end to a stressful collection calls and letters
- It consolidates multiple loan payments into easy to pay and easy to remember payments.
- Possible reduction in interest rates, fees and monthly payment amounts.
- Will give you a clear idea of a definitive date when you’ll be done paying off all your debts.
- Helps you to improve your credit and credit scores in the long term
The Disadvantages of a Debt Management Plan
In the short term it can negatively affect credit scoring in several ways:
- Mandatory closure of credit card accounts will affect your credit utilization ratio
- Closing accounts can affect account age. The length of time you’ve been using credit is also considered by many credit scoring models.
- How the accounts are settled or closed or restructured — whether paid in full or settled for less than the full amount owed — can have influence on your credit score.
So now what are you waiting for? Turn your hard tides over and start building positive net worth from now. Better late than never