Debt can ruin your finances easily if you don’t deal with it properly. Understanding different types of loan and its impact on your finance is necessary. In this article, we will discuss good loan and bad loans and the different loan repayment and prepayment strategy.
These concepts are developed based on the characteristics of the loan. If a loan has a lower interest rate and tax benefits are also available, such loans are considered as good loans. For example Home loan.
A loan with higher interest rates like personal loans, credit cards are considered as bad loans. Because it is having an adverse impact on your savings
Let’s discuss in deep about loan payment strategies:
- The Debt Snowball
- The Debt Avalanche
The Debt Snowball method
This method is developed by a famous financial advisor of USA, Dave Ramsey. This method has more focus on psychology rather than on financial aspects. The goal of this method is to give your psychological relief that loans are getting paid off faster.
Step1: Prepare a list of all loans pending
Step2: Arrange this loans in order from lowest to highest outstanding:
Roll the snowball slowly. Start paying the debt from lowest amount outstanding. By doing this, no. of loans will be reduced speedily. This will give mental peace.
Here in the above example, a personal loan should be paid first, then a credit card, car loan and at last home loan.
The Debt Avalanche
This method takes interest rate into consideration rather than amount of loan outstanding.
Step1: Prepare a list of all loans with interest rates.
|Particulars||Interest Rates (p.a.)|
Step2: Arrange this loans in order of highest to lowest interest rates:
|Particulars||Interest Rates (p.a.)|
Start repaying in order of step2. This is more logical way as compared to debt snowball method. As loans with higher interest rates is something you should avoid.
If you have followed the debt snowball method, you would have start paying personal loans first. This will lead to too much of interest penalty on a credit card due to a high-interest rate of 36% p.a.
I have tried both methods. I believe that no method is correct or full proof.
You should take advantages from both the methods and develop your own.
|Particulars||Amount outstanding||Interest Rates (p.a.)|
From the above we can make out that although personal loan is having lowest outstanding balance, it should not be paid first. Credit card payment should be priority as interest rate is too high and penalty is hefty. After credit card, personal loan should be paid followed by car loan.
It doesn’t mean that you will only pay one loan at a time. You should be paying minimum EMI required for all the loans(except credit cards)
Some loans like, the home loan should not be paid of early because of tax benefits and lower interest rates.
What to do if one receives lumpsum money:
- Prepay loans with higher interest rates
- If you have loans of low-interest rates, invest your money in your financial goals
With regular income and savings, should you save for your goals or prepay your loans?
First check out whether, any extra penalty is charged for extra payment other than EMI on your loan? If yes its better to avoid. But if such loan is with higher interest rates like 12 to 15%, then some portion should be kept aside every month and once in a year, extra payment should be done.
If no penalty is charged and interest rate is high, you should reduce the term period and increase EMI value.
Follow these steps to pay all your loans.
Try to be debt-free as early as possible. This day it’s very easy to take a loan. So people tend to take more loan than what’s needed
I earlier said in Day 0, that when banks and financial institutions start using FOMO (Fear of Missing Out), it will harm you adversely.
Stay away from the loan as much as possible. Plan your finances and investments in such a way that you need to take any loans.