Debt, in one form or the other, is part of every person’s financial situation. This usually happens because some expenses cannot be met from savings alone. It could arise from, say, funding the purchase of a house or even a higher education. These may need some loan amount to ensure that the goal can be met at a time that best suits your needs.
A loan may also be required to meet unexpected and large expenses, such as medical emergencies. Or, you may be the person who tends to run up debt on credit cards.
Whatever the reason may be for taking on debt, there is always the intent to manage it properly and pay it off at the earliest. This is best done with a plan that considers the features of the debt, so that allocation of funds can be prioritized from available income. This will help meet repayment obligations as well as rank the debt for prepayment if funds are available for you to pay off or close a loan.
One of the more important elements that will help you draft such a plan, and actually make it work, is to understand the features of the outstanding debt and how it impacts your personal situation.
Good for You or Not
For the more financially prudent, debt may be the thing that adds value to your financial situation, such as a home mortgage or an education loan. Debt, such as student loans, can be used to improve your income-earning capability, while the effect of leveraging enhances the benefits of using loans to buy appreciating assets like real estate. These are loans that help improve your net worth over time.
But for the less prudent, debt typically proves to be a drain on resources, for example, credit card dues from spending. This kind of debt over a period of time undermines your financial stability. With such debt, you may find that the loan repayments leave very little of your income for savings, or to even meet your essential expenses and commitments.
Unless you get this type of debt under control, you may find yourself in a position where you may not be able to access funds when you actually need it in an emergency.
High or Low
Some loans, like personal loans, come under the category of high-cost debt, while others, like a mortgage, are typically a lower-cost debt. If you had the option of paying off some loan, it would be a good idea to clear the debt with higher interest cost. Not only do you pay a high cost for them, they are also likely to have a high penalty associated with them for any default or delay in repayment.
Paying off loans with higher interest costs and penalties—such as credit card outstanding—frees your income for other goals. Some loans are typically large-ticket, such as a mortgage or an auto loan. Finding the excess funds to pre-pay such large loans may not be easy and it is best done in instalments. Smaller-sized loans are easier to pre-pay.
Being able to cross off a loan from a list of outstanding debt can be a motivator to continue the good work to generate surpluses to pay off other debt as well.
Secured or Not
Loans, such as auto loans and mortgages, are secured on the assets they have funded. If the obligations arising from the loan are not met, the borrower may lose the asset.
Others, such as personal loans and credit card loans, are not secured and hence the risk to the borrower is lower.
Therefore, when you are apportioning income to meet repayment obligations, secured debt should get priority before others in order to protect the assets.
Other Features
Some debt, like student loans and house mortgages, provide tax benefits which bring down the real cost of borrowing. Such loans can come lower in the order on the prepayment ladder.
Most loans are for a fixed period after which the lender can initiate action for recovery of dues. Thus ensuring that the obligations are met on time is important. Others, such as credit card dues, can be extended by paying a penalty, albeit high, which gives you some wriggle space on repayment when income is tight.
Some debt is more flexible on repayment terms and this could be used to your convenience. For example, repayment of student loans typically commences only once you are steadily employed. Use this provision to focus on other more pressing debt.
The features of the debt you hold will influence how you prioritize it for meeting the regular repayment obligations. Rank your debt in order of the impact they have on your financial situation, with debt that takes away from your well being higher up on the list and those that add to it coming lower down. Use it to guide you when you make decisions on managing debt.
