This week, as India celebrates its 78th anniversary of independence, have you thought about what financial freedom means to you? For many, it means having savings, investments, cash reserves, a solid retirement fund and the freedom to pursue their chosen career. However, the first step to achieving all of this is becoming debt-free. “Reducing or eliminating debt frees up funds for goals like buying a home, children’s education and retirement,” says Jinal Mehta, founder of Beyond Learning Finance.
According to a report by Motilal Oswal, household debt in India has been rising and hit a record 39.1 per cent of gross domestic product (GDP) in the third quarter of fiscal year 2024. In its Financial Stability Report of June 2024, the Reserve Bank of India (RBI) had noted that with household savings declining and financial liabilities rising, household debt deserves close monitoring.
Below are strategies that borrowers looking to escape a debt trap can adopt:
Debt settlement
Debt settlement involves negotiating a payment that is less than the total amount owed, such as settling a Rs 400,000 credit card bill for Rs 225,000. While this may seem like a money-saving option, it has significant drawbacks.
“Failing to pay in an attempt to reach a settlement can result in late fees and penalties. This debt also gets marked as ‘settled’ on your credit report, which hurts your credit score and future access to credit,” says Adhil Shetty, CEO of Bankbazaar.com.
If you choose this strategy, negotiate the settlement amount directly with the lender. If you use an outside company, make sure it is approved by the bank. Get a settlement agreement in writing.
Debt consolidation
Debt consolidation involves taking out 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 lower-rate ones or by increasing the term to reduce the monthly payment.
Shop around. “Don’t settle for the lowest monthly payment or the first interest rate offered, as these can increase your total interest costs,” says M. Barve, founder of MB Wealth Financial Solutions.
Please note that access to new loans may be limited until you pay off the consolidated debt.
Avalanche of debt
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 of them to avoid default, and then use any surplus to prepay the debt with the highest interest rate.
“The debt avalanche strategy is the one that saves the most on interest costs,” says Mehta.
If your highest-cost debts are your largest loans, you will see slower progress at first. It also limits the savings available to the borrower.
Snowball of debt
With the snowball method, the borrower pays off the smallest debt first and then gradually works his way up to the largest, regardless of the interest rate. Make the minimum payments on all debts, then use the extra funds to pay off the smallest debt first. After that is paid off, move on to the next smallest debt.
“Offering a quick solution to debt repayment increases trust, but it is more costly,” says Barve. Research shows that this strategy works better from a behavioural perspective.
Borrowers can also combine strategies. Start with the snowball method and pay off the smallest debt first, then use the extra funds to tackle the higher-interest debt. This approach strikes a balance between reducing the cost of interest and building confidence.
Consider debt consolidation if you have multiple high-interest debts to manage. Use settlement only as a last resort.
How a credit card balance transfer works
Aim:Consolidate multiple credit card debts into one, reducing financial strain and potentially improving your credit score.
Interest: They offer lower interest rates, often 0%, and interest-free periods on new purchases if the balance is paid on time.
AdvantagesThey offer introductory rates and extended interest-free periods, which helps in debt consolidation and reduces financial stress.
Avoid:Using balance transfers just to delay payments without curbing spending can be counterproductive
Advice:See the terms of the new card, including rates, fees, and duration of the promotional offer; pay the balance before the offer expires.
First published: August 13, 2024 | 10:56 PM IS
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