We keep receiving questions on ‘how to pay off massive debt’ or ‘how to reduce large debt’ from people who find themselves in spiralling debt traps.
Today, we will try to give you some specific and generic pointers to reduce your debt the fast and comparatively easy way. For this, we will take a question we received recently from someone who had fallen into a debt trap.
The person had around ₹50 lakh in personal loans and credit card debt accrued over several years. Their personal income after taxes was around ₹12 lakh or around ₹1 lakh a month.
Now here is something you have to remember about banks. They do not give loans if they see you don’t have the ability to repay. More specifically, they would like to see that you have at least 40% of your salary left over after your EMI payments. In case you are wondering whether it is 40% of gross pay or net pay, then some banks look at gross salary for this while others look at net take-home pay after EMI deductions. Others may look at the average monthly balance in your account. The specific criteria are different for banks but the ‘40% of net salary left over after EMI’ is more or less a good rule of thumb to keep in mind.
(For reference, you can see our earlier two posts on top personal loan providers in India or visit our primary website for more information on different types of personal loans you can use to pay off your debts.)
Another thing for you to remember, it is far easier to get a secured loan and that too at a lower rate of interest and for a longer tenure than it is to get an unsecured personal loan, especially if you are already in a debt trap.
In the present case, since our questioner had around ₹1 lakh in personal income, they were likely to get at most loans upto ₹60,000 in EMI.
This is what we suggested:
Seek Financial Advice from Experts
Firstly, if they can get to a financial adviser nearby. This is not something we Indians appreciate but paying a certified financial adviser for sound and practical advice to get out of debt and grow our wealth is one of the best things you can do for yourself and your family.
Next Best Thing to do if No Financial Experts are Available
If they could not hire a financial expert, then here are the next best things they can do to reduce their debt:
Take a Secured Loan to Pay-Off Personal Loans and Credit Card Debt
A secured loan, especially a mortgage, is a great tool to become completely debt free. A loan against property or a home equity loan comes at lower rates of interest and considerably longer repayment tenure. Here are some calculations:
- ₹50 lakh in personal loan debt will have an interest rate of 18% at the very least and come with tenures of 5-7 years at most. The credit card debt will have higher interest rates and shorter repayment tenures. Even if we take the interest on ₹50 lakh at 18% interest and for 5 years, the EMI will come to over ₹1,27,000 – much more than what our friend has as monthly income (₹1 lakh)
- The same loan amount (₹50 lakh) at an interest of 12% (what one is likely to get from a loan against property) for a 12-year tenure brings the EMI down to ₹66,000, a drop of over ₹60k per month. This EMI will not only allow our friend to live their regular life but also allow them to save more to pay off the EMI more quickly
If a Secured Loan for Full Amount is Not Possible
If the individual cannot get a secured consolidation loan for the total loan amount, then they should try to get a secured loan for at least the credit card debt at first. This debt though sounds cheap at say 2% – 3% monthly interest is in reality anything but cheap.
A 2% per month credit card will cost you upwards of 27% per year. Reducing this credit card debt into a secured loan that will come at a lower rate of interest (say around 15%) and a longer repayment tenure (5 years vs 3 years at present) lowers the overall monthly debt repayment and make the debt more manageable.
Note: Once the loan taken to pay off the credit card debt is repaid, one can take a secured loan again to pay off the remaining personal loan debt. This question, however, is best addressed once one has compared the cost benefits at that point in time
What to Do if a Secured Loan is Not Possible At All
This is what should be done if a secured loan is not at all possible.
Break Down the Debt
The most practical way out will likely be to break down the total debt into different amounts – such as credit card 1, credit card 2 and so on, and then start paying them off one at a time instead of all at once.
Pay Off the Smaller Loans First
They should start with the smallest debt and work upward to the higher loans. This considerably reduces the overall debt. For example, if we assume that our friend had say 3 credit cards with debt of ₹10 lakh, ₹5 lakh and ₹3 lakh, then they should pay these off in this order:
- Pay off ₹3 lakh first in 8 months to a year at most
- Next, pay off ₹5 lakh in the next year
- Thirdly, pay off the final ₹10 lakh in at most 2 years
Convert Credit Card Debt into Personal Loans
They should at the same time, talk to the credit card companies to turn their credit card debt into one personal loan. This will reduce their credit card debt that comes with annual interest rates of 27% or more into lower-cost loans that have around 18-20% as interest at most. If we take the above examples:
- ₹18 lakh in credit card debt at a conservative 27% interest payable in 3 years, comes to a payment of around ₹74,000 every month
- The same amount turned into a personal loan at 18% interest rate in 3 years brings down the monthly payment to ₹65,000. The ₹9,000 saved can be added to pay off more of the remaining EMI
An important note here. Taking a personal loan to pay off only the credit cards does not solve the problem much. For instance, in the above example, even if our friend reduces their EMI for the cards to ₹65k, they will still have to pay the EMIs on the remaining debt (total debt less credit card debt). The two EMIs will still add up to more than what our friend earns. This is why we recommend a financial expert.
Talk to the Personal Loan Banks to Take Over the Debt
If talking to the credit card company does not work (it usually should) or if they are interested in reducing the rate further, they should talk to the bank from which they have taken their personal loans. The bank can take over the credit card debt and turn them all into one personal loan with a considerably lower rate of interest and a longer tenure.
This is something banks do on a regular basis, as they are getting a new paying customer at no cost. They also offer better rates than what the credit card company will offer (from around 27-30% per year to around 15% or less). This reduces the outgo again. One can always ask for the maximum tenure available. In most banks now, this has increased from the previous 5 years to 7 years. This will likely increase more due to macroeconomic factors but 7 years is good enough for now.
If we take the same calculation we had done earlier (₹50 lakh loan at 18% interest) but extend the tenure to 7 years from 5, then the EMI drops down to ₹1.05 lakh from ₹1.27 lakh – still more than what our friend earns. That is why our friend should try for as low a rate of interest as possible. A 12% interest drops the EMI down to around ₹88,000 – still not a practical number but a beginning nonetheless.
Come to an Arrangement with the Credit Card Company
This is not advisable but if you have no means to pay off your debt, then coming to an arrangement may be the only way forward. This will affect your credit score and will always remain as a black mark in your credit records. This will always affect your ability to take a loan in the future. Now that you know the consequences of this action, let us understand what it is all about.
When a credit card company gives you a credit card, it is in essence giving you a personal line of credit. All you need to do is show your card when making a purchase and the company extends you enough credit to pay for your items. They then ask you to repay the amount by the specified timeline or else they will charge you a rate of interest on the amount due that was not fully paid off within that timeline.
When you max out your card or you spend a considerably larger amount than what you can pay off easily, then there are two components to your monthly credit card statement. One is the credit the card company has extended you and the next is the interest. As you use your card and only partially repay the amount due, then you pay interest to the credit card company on the remaining due amount.
Over time this adds up to a large amount. So when you are unable to repay or only pay the minimum due, then the company understands it is in its best interest to get back the credit they extended to you and forgo the interest you cannot pay back. They have earned enough interest from you over the years to recover their costs and earn a profit.
So, the company offers you an arrangement where they ask you to repay the amount you can pay back. They ask you to pay the maximum you can but you can drive a good bargain here for a smaller amount. If needed, they break up the due amount into smaller parts that they ask you to repay over the course of the next few months.
It helps if you have a financial expert guiding you at this stage. So, before we close this part of this three-part series on how to pay off massive debt, let us again urge you to consult an expert to help you navigate the complex issues related to debt repayment.
In the next part of the series, we look at some practical steps to help you pay off your debt faster.