Everyone I know is trying to lose weight these days. They diet to keep the bad calories away, exercise to burn the extra flab and try hard to curb binging sprees. Managing debt is pretty much the same. You need to keep the high cost debt away, work toward lowering your interest cost and avoid excessive spending.
The usual thumb rule that most Financial Planners recommend is to keep your monthly debt payments restricted to 20-30% of your income. If you think you are exceeding that, its time to go on a debt diet. Here’s what you need to do:
Step 1: Take stock of all your outstandings
Just like a Weight loss program begins with a physical examination of your current health, such as weight, BMI, body fat etc, a debt diet too begins with taking stock of your current debt. Then set yourself a goal. If your debt repayment takes up 60% of your monthly income, target to bring that down to 30%.
Step 2: Differentiate between good debts and bad debts
Good debt is something like your home mortgage or an education loan. These debts are good because they go toward creating an asset or furthering your income earning capacity. Moreover, you also get certain tax benefits.Credit cards and personal loans are relatively bad debts because they are expensive. These debts also tempt you to spend beyond your means.
Step 3: Rank debts in order of cost
Usually debts like home mortgages and study loans are cheaper whereas personal loans are more expensive. Credit card debt is the most expensive form of debt. Rank all your debts in order starting with the most expensive.
Step 4: Start repaying; prepay if possible
The ranking will help you decide which loans to repay first. It does not matter if the credit card outstanding is small. The interest rate is so high that once it starts accumulating, the debt will grow to a large amount.
Prepay, if possible, high interest loans. If you land a lump sum of money, consider prepaying your debts. Often the dilemma with lump sum monies is whether to invest or prepay a loan. The answer would depend on the potential of your investment to earn returns. If the opportunity of returns is higher than the cost of debt, you must consider investing.
Step 5: Substitute high interest loans with low interest loans
Even after this exercise if you are left with high cost debts, see if you can substitute high cost debts with relatively lower cost loans. For instance, see if you can convert your credit card outstanding into a personal loan, or even better, some form of securitised loan.
Like any weight loss program, there are no quick fix solutions. Bringing down your debt takes a lot of discipline and consistent effort.