This post was most recently updated on November 18th, 2022
Having debt is the biggest burden that anyone goes through in their life. Debt forces you to make difficult decisions in life and sometimes drains you mentally. In this article, let’s understand how to get out of debt in 5 steps.
Is it Better to Pay off Debt or Save Money?
There are two approaches to this:-
1. How to get out of debt – The Mathematical Approach to Debt Versus Savings
Before you take any decision on paying off a debt you need to evaluate what debt you have and what is the interest rate for those debts you have taken.
There are debts like credit card debts which carry a very high-interest rate which is really bad to have but on the other hand debts like a house, or a loan is sometimes good to have. so while you are evaluating to pay off debt consider the below method to differentiate between a good debt and a bad debt:-
- List down all the debts you have
- list the interest rate you are paying for the debt
- check how much interest you have already paid and how much is remaining. If you have already paid the interest for the debt then there is no point in paying off the debt as it’s only the principal amount that is remaining to be paid.
- how much money you will save paying off debt as opposed to investing the money in an instrument that will give guaranteed returns(like a bank savings account)
If you need help comparing debt to savings, there are online calculators that can help determine which is a better priority for your excess income.
2. How to get out of debt – The Emotional Approach to Debt Versus Savings
Sometimes people get too emotionally involved in debt so they just want to get rid of debt even though that may not be the right decision. Although it’s good thinking to get rid of debt but make sure you are not getting rid of debt just because it’s troubling you emotionally.
For example:- If you have a home loan that gives you tax breaks and low-interest rates then it’s sometimes wise to keep that kind of debt with you which will only help you manage your money better.
How Do You Calculate Whether to Pay Off Debt or Save?
The first thing you need to understand about debt is – all debts are not the same!
Credit card debt – A credit card debt often has the highest interest (few credit card debts are as high as 36% per annum- you read this right, some credit cards charge you up to 3% per month leading to 36% per year).
you should absolutely make sure that you shouldn’t be taking these types of debts in any circumstances. These debts will just rip you apart and take all your savings out!
Car loan- Car loans are generally not as expensive as credit card loans and hover around 10-12%(this is also high considering a bank deposit only gives you around 6% interest) so unless you can’t afford a car, you should skip the car loan.
Personal loan – Personal loans are also expensive, they are generally in the 12-14% range. So you should skip personal loans as much as possible.
House loan – With falling interest rates the housing loan rate has also decreased. Some of the banks are offering house loans at around 6-7%. Considering house loans also give you tax breaks, it is wise to have a housing loan if you need one.
How to get out of debt – A Step-by-Step Plan
If you are feeling a bit overwhelmed with all these debt options and interest rates then don’t worry, we will go through a step-by-step guide to make sure you take the right decisions on managing your debt.
How to get out of debt in 5 steps
Step 1: Start contributing to your retirement fund
People often take this as the least priority as they have an attitude that they won’t have a life after retirement. But retirement will come ..it will definitely come and the sooner you start contributing to your retirement the less you need to keep aside every month when you grow older. NPS is a great instrument for retirement funds. It gives you additional tax benefits when you contribute to it.
Step 2: Build an Emergency Fund of Savings
Emergency fund is the most ignored concept in the current world. People do not understand the real meaning of emergency funds. They assume their investment into PPF, Stocks, Mutual funds are part of their emergency fund.
An emergency fund is something that you can bank on in difficult times such as losing a job unexpectedly or someone in your family meeting with an accident.
You should be keeping this money aside in a liquid instrument which you shouldn’t touch without an emergency!
If you rent and are just starting your career, you can probably get by with a mini emergency fund of 50000 to 100000. If you own a home or have children, you should try to have three to six months’ worth of income in your emergency fund. That way, you can handle just about any emergency that comes your way, even losing your job.
Step 3: Focus on Paying Off Debt with High-Interest Rates
Now that you’re contributing to your NPS and have a small emergency fund, turn your attention (and excess income) toward your debt. Any debt you have with high-interest rates, or rates higher than 9%, is first to go.
Interest rates this high will likely cost you more money than you would make on most investments. Paying these debts off as soon as possible means you’ll pay less in interest.
If you have a high-interest debt like credit card debt and if you have some savings in form of bank deposits then you should consider breaking your bank deposit to close your credit card debt.
Consider this, Your bank deposits may be giving you 6% p.a. interest but you are paying 36% p.a interest for your credit card debt.
Step 4: Decide Your Savings and Debt Priorities
Now that you are aware of how to get rid of high-interest rate debts, you are probably left with low-interest rate debt like a house loan.
remember having a house loan is not necessarily a bad thing! In some cases, it may be a better deal than investing the money. House loans often come with many tax breaks which may work out best for you.
So before you start thinking of getting rid of low-interest rate debts like a house loan, please evaluate the mathematical gain that you get by repaying the low-interest debt!
Step 5: Stick to Your Spending Plan and Keep Building Your Savings
key thing about managing debt is to know yourself and keep a plan about your spending! it’s often seen that people end up at a losing end just because they are too lazy to manage their finances.
Sometimes it’s the psychological fear that restricts someone to plan for their personal finances.
Remember- You are working hard to make money, don’t let your laziness come in the way of managing your personal finances!