TomorrowMakers

Get rid of your debt, as it is a disease. Familiarise yourself with these strategies to pay off your debts.

Debt pay off strategies you should know about

Do you have your credit card dues under control? Apparently, most plastic money users in India do, but are you among them?

Credit card usage tracker CIBIL says 9 out of 10 Indians are aware of the pitfalls of not paying their credit cards bills, or even postponing payment: it can adversely affect their credit score. As a result, an overwhelming 92% clear more than the minimum monthly dues, CIBIL data shows.

If you are not among this 92%, you could be in danger of becoming like US debtors. American households on an average have $15,000 in credit card dues, aggregating a national debt of $800 billion, say researchers quoting figures from the Federal Reserve. 

You should familiarise yourself with the various strategies that people in the US and elsewhere follow to pay off their debts – the avalanche, snowball, and snowflake methods. Once you understand each of these, you will be in a better position to decide what suits you best. 

Motivating debtors

Interestingly, the researchers propose for American debtors what Indians already practise: pay more than the minimum due. ‘Consumers must regularly decide how to allocate repayments, above minimum requirements, among their different accounts,’ they wrote in the Harvard Business Review.

However, the big question remains: how does one decide the payment amounts for ‘different accounts’ or multiple credit cards, which is more often the case than not? Should they disperse payments equally for all cards every month or focus on just one?

The writers say they researched the question for the Chicago-based Journal of Consumer Research, belonging to the Oxford University Press (OUP), and found that debtors paid off more dues if they focused on just one card, than if they made equal payments across multiple cards. 

‘Concentrated (as against dispersed) repayment strategies tend to boost consumers’ motivation to become debt-free, leading them to repay their debts more aggressively,’ the study says. What this means is that if debtors begin by focusing on just one card, the chances of clearing all dues over a period of time was greater.

More importantly, the study says, the ‘motivating effect’ was the most pronounced when repayments were for the smallest debts, as debtors saw reduction of dues under any one account as being an ‘overall progress in debt repayment’. 

So the OUP researchers are basically saying: (a) start off with the smallest dues on any one card and (b) begin by paying more than the minimum due.

Debt snowball method

By calling for starting off with the smallest dues, what the researchers are advocating is the Debt snowball method, where you pay off your debts from smallest balance to the largest, regardless of interest rates.

This method has been popularised by American businessman and author David Ramsey, whose company is into financial education; it has a cult following in the US. People are generally overwhelmed by the numerous small debts lying around, and this method helps them cope.

“Do you remember building snowballs in the backyard as a kid?” Ramsey writes on his website, referring to the technique of rolling a snowball down the road, so that it grew in size. ‘It was a good technique for building snowballs as a kid, and it’s an even better method for paying off your non-mortgage debt.’

This is how: in the debt snowball method, you begin by paying the smallest dues, and start clearing the little debts very quickly. As you go along, the repayments/clearance gains momentum, like a snowball. The debt snowball method takes the following steps:

  • First, clear the minimum monthly due on all of your debts;
  • Next, use any leftover money to target the smallest debt;
  • Once that is paid off, devote its previous monthly payment and leftover money to your next-smallest debt.

As the OUP researchers found out, the debt snowball method motivated debtors; they ‘saw quick progress’, so by the time they start tackling the larger debts, they would have the confidence, ability, and extra cash flow to make it to the end. People have got rid of entire debts every few months this way.

Debt avalanche method

Another popular strategy is the debt avalanche method; here too you make minimum payments, and as each debt is cleared, its minimum due gets added to the monthly due for the next. However, in this method you go for debts with the highest interest rates first, and not the ones with the highest balance amount.

Once the debt with the highest interest rate is squared off, the extra repayment funds go toward the next highest interest-bearing loan. It has been seen that mathematically, the debt avalanche method makes the most sense, as the payout is less in interest if you tackle your debts in this order.

Also, you are more likely to pay off debts faster by this accelerator plan – hence the ‘avalanche’ in the name. Plus, you save the most on interest payout. The idea here is: why pay dues on a card that is not charging any interest when you have one that is charging 18%? Which makes sense to clear first?

But while the debt avalanche method cushions the impact of interest payouts, it is essential you stick to the plan diligently for it to succeed; this strategy requires utmost discipline and commitment. It is tempting to revert to making minimum payments when an unforeseen expense crops up – for instance, repairs on your car. 

This is why financial planners often advise debtors to save and set aside an emergency fund before attempting the debt avalanche plan.

Debt snowflake method

The debt snowball and the debt avalanche methods are two sides of a coin: you plan for both and commit a certain amount to pay off your debts. You know how much you earn, and from that you keep aside the debt repayment amount.

However, there is a third way – the debt snowflake method. It is perfectly compatible with the other two, because it does not replace either; it only complements whichever strategy you are following. It’s called the debt snowflake method because like snowflakes that collect to form a nice carpet of snow, this strategy accumulates day-to-day savings into a tidy sum that can help you pay off your debts. 

Then, every so often people come across some unexpected income; or even if expected, it is from outside the monthly salary – such as income tax refunds, annual bonus, or a kitty party earning. This extra income adds to the amount that can go into further reducing your debt. It is like a snowflake adding to the carpet of snow.

Last word

Whichever debt reduction method suits you, follow it. Get rid of your debt, as it is a disease. It will influence how much you invest, how aggressively you invest, and also have a bearing on your retirement savings. If your debt has interest, it means it will keep swelling every day. 

It is essential to recognise this fact. Live within your means and, if necessary, be a miser for while. It is better to live on a budget than to have your life sucked out of you. Remember, 92% of your fellow Indians already have their credit card debt issues sorted. Be like them!

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or insurance or tax or legal advice. You should separately obtain independent advice when making decisions in these areas. 

Written by Gopal Gidwani

Gopal Gidwani is the owner of www.bachatkhata.com, a personal finance website on financial planning, banking, insurance, capital markets, taxation, saving and investing money.

Do you have your credit card dues under control? Apparently, most plastic money users in India do, but are you among them?

Credit card usage tracker CIBIL says 9 out of 10 Indians are aware of the pitfalls of not paying their credit cards bills, or even postponing payment: it can adversely affect their credit score. As a result, an overwhelming 92% clear more than the minimum monthly dues, CIBIL data shows.

If you are not among this 92%, you could be in danger of becoming like US debtors. American households on an average have $15,000 in credit card dues, aggregating a national debt of $800 billion, say researchers quoting figures from the Federal Reserve. 

You should familiarise yourself with the various strategies that people in the US and elsewhere follow to pay off their debts – the avalanche, snowball, and snowflake methods. Once you understand each of these, you will be in a better position to decide what suits you best. 

Motivating debtors

Interestingly, the researchers propose for American debtors what Indians already practise: pay more than the minimum due. ‘Consumers must regularly decide how to allocate repayments, above minimum requirements, among their different accounts,’ they wrote in the Harvard Business Review.

However, the big question remains: how does one decide the payment amounts for ‘different accounts’ or multiple credit cards, which is more often the case than not? Should they disperse payments equally for all cards every month or focus on just one?

The writers say they researched the question for the Chicago-based Journal of Consumer Research, belonging to the Oxford University Press (OUP), and found that debtors paid off more dues if they focused on just one card, than if they made equal payments across multiple cards. 

‘Concentrated (as against dispersed) repayment strategies tend to boost consumers’ motivation to become debt-free, leading them to repay their debts more aggressively,’ the study says. What this means is that if debtors begin by focusing on just one card, the chances of clearing all dues over a period of time was greater.

More importantly, the study says, the ‘motivating effect’ was the most pronounced when repayments were for the smallest debts, as debtors saw reduction of dues under any one account as being an ‘overall progress in debt repayment’. 

So the OUP researchers are basically saying: (a) start off with the smallest dues on any one card and (b) begin by paying more than the minimum due.

Debt snowball method

By calling for starting off with the smallest dues, what the researchers are advocating is the Debt snowball method, where you pay off your debts from smallest balance to the largest, regardless of interest rates.

This method has been popularised by American businessman and author David Ramsey, whose company is into financial education; it has a cult following in the US. People are generally overwhelmed by the numerous small debts lying around, and this method helps them cope.

“Do you remember building snowballs in the backyard as a kid?” Ramsey writes on his website, referring to the technique of rolling a snowball down the road, so that it grew in size. ‘It was a good technique for building snowballs as a kid, and it’s an even better method for paying off your non-mortgage debt.’

This is how: in the debt snowball method, you begin by paying the smallest dues, and start clearing the little debts very quickly. As you go along, the repayments/clearance gains momentum, like a snowball. The debt snowball method takes the following steps:

  • First, clear the minimum monthly due on all of your debts;
  • Next, use any leftover money to target the smallest debt;
  • Once that is paid off, devote its previous monthly payment and leftover money to your next-smallest debt.

As the OUP researchers found out, the debt snowball method motivated debtors; they ‘saw quick progress’, so by the time they start tackling the larger debts, they would have the confidence, ability, and extra cash flow to make it to the end. People have got rid of entire debts every few months this way.

Debt avalanche method

Another popular strategy is the debt avalanche method; here too you make minimum payments, and as each debt is cleared, its minimum due gets added to the monthly due for the next. However, in this method you go for debts with the highest interest rates first, and not the ones with the highest balance amount.

Once the debt with the highest interest rate is squared off, the extra repayment funds go toward the next highest interest-bearing loan. It has been seen that mathematically, the debt avalanche method makes the most sense, as the payout is less in interest if you tackle your debts in this order.

Also, you are more likely to pay off debts faster by this accelerator plan – hence the ‘avalanche’ in the name. Plus, you save the most on interest payout. The idea here is: why pay dues on a card that is not charging any interest when you have one that is charging 18%? Which makes sense to clear first?

But while the debt avalanche method cushions the impact of interest payouts, it is essential you stick to the plan diligently for it to succeed; this strategy requires utmost discipline and commitment. It is tempting to revert to making minimum payments when an unforeseen expense crops up – for instance, repairs on your car. 

This is why financial planners often advise debtors to save and set aside an emergency fund before attempting the debt avalanche plan.

Debt snowflake method

The debt snowball and the debt avalanche methods are two sides of a coin: you plan for both and commit a certain amount to pay off your debts. You know how much you earn, and from that you keep aside the debt repayment amount.

However, there is a third way – the debt snowflake method. It is perfectly compatible with the other two, because it does not replace either; it only complements whichever strategy you are following. It’s called the debt snowflake method because like snowflakes that collect to form a nice carpet of snow, this strategy accumulates day-to-day savings into a tidy sum that can help you pay off your debts. 

Then, every so often people come across some unexpected income; or even if expected, it is from outside the monthly salary – such as income tax refunds, annual bonus, or a kitty party earning. This extra income adds to the amount that can go into further reducing your debt. It is like a snowflake adding to the carpet of snow.

Last word

Whichever debt reduction method suits you, follow it. Get rid of your debt, as it is a disease. It will influence how much you invest, how aggressively you invest, and also have a bearing on your retirement savings. If your debt has interest, it means it will keep swelling every day. 

It is essential to recognise this fact. Live within your means and, if necessary, be a miser for while. It is better to live on a budget than to have your life sucked out of you. Remember, 92% of your fellow Indians already have their credit card debt issues sorted. Be like them!

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or insurance or tax or legal advice. You should separately obtain independent advice when making decisions in these areas. 

Written by Gopal Gidwani

Gopal Gidwani is the owner of www.bachatkhata.com, a personal finance website on financial planning, banking, insurance, capital markets, taxation, saving and investing money.