Imagine that you do not have to pay any more EMIs every month. That sounds really nice. However, is it possible to lead a debt-free life as most of us are burdened with car loan, education loan, personal loan, credit card outstanding, etc?
So, how can we turn this dream into reality? It is possible to make this dream a reality by following a very popular and proven model in investment science literature known as ‘debt snowball method’. Let us discuss the same in detail here:
What is debt snowball and how it works
It is just contrary to what many people believe —one should pay off the debt with the higher interest rate first to get out of debt quickly —meaning that you should start paying the smallest debt first in order to create a momentum in your debt snowball. But, is it against our conventional wisdom to pay the debt with highest interest rate first, which will save you the most money?
Perhaps true, but if you start with the biggest one, probably you may think that you are not making significant progress and lose steam and even possibly quit before getting closer to full repayment.
So, it is essential to pay your debts in a way that keep you motivated until you have cleared them all. Following is the step-by-step process you should follow: (i) List your loans from smallest to largest; (ii) Make minimum payment to all your loans except the smallest; (iii) Pay as much as you can on your smallest debt; (iv) Repeat until each debt is paid in full; (v) If you have any additional cash inflow utilise the same to pay off the smallest loan.
Let us take an example and see how it works: You have four types of loans as follows: a) Credit card 1: Rs 25,000 outstanding with an interest of 18% and monthly payment of Rs 1,250; b) Credit card 2: Rs 50,000 outstanding with an interest of 24% and monthly payment of Rs 2,500; c) Car loan: Rs 3,00,000 with an interest rate of 9% payable over a period of four years with a monthly EMI of Rs 6,750; d) Education loan: Rs 7,50,000 with an interest rate of 5% payable over a period of 10 years with a monthly EMI of Rs 7,950.
Let us assume that you pay the minimum amount on each outstanding loan and add an extra Rs5000 to the smallest credit card payment, you will pay it off in four months. Then you can focus on the second credit card to the tune of Rs 8750 per month (Rs 5000 plus the newly freed-up i.e. Rs 1,250 plus the Rs 2500 payment you’re already making). That one will be gone in five months. Now you have Rs 15,500 a month (Rs 8,750 plus Rs 6,750) to put toward the car. At that rate, the car loan will hit the road in 15 months.
By the time you get to the student loan, you will be paying Rs 23,450 on it each month. You will say goodbye to all the loans in another 24 months and be totally out of debt. This is what happens when you have focused with intensity and start with your smallest debt to and it leads to big results. However, be aware that waiting to pay off high-interest bearing debt is likely to cost you in terms of more interest outflow and increase the amount of time you spend in debt.
To conclude, if you are a person who needs encouragement, the debt snowball method is the right method. In the end, the only inarguable point about paying off debt is that you must be committed to the process.
(The writer is a professor of finance & accounting, IIM Tiruchirappalli)