Step 1: Take stock of all your credit outstandings
The best way to get started is to take stock of what you’ve been doing with your credit status. Classify your debts. Debt is either good or bad debt. Good debt is something like your home loan or an education loan. It’s good because interest rates are relatively low, you get a tax benefit and the loan goes toward making a useful investment. Credit cards and personal loans are bad debt because they are very expensive. They are also easily available these days and could tempt you to spend beyond your means.
Step 2: Rank debts in order of cost
Interest rates vary largely across loan categories. The rate of interest is attached to the risk involved in giving out the loan. A loan with relatively lesser requirement of collaterals and security will be more expensive than a loan that is secured. A home loan is secured against property but credit cards are mostly unsecured. Hence a home loan may cost you 10.25% per annum in interest but a credit card may cost you up to 36% for a year. Rank all your debts in order starting with the most expensive.
Step 3: Start repaying
Start repaying in the order of ranks. First, repay the high cost debts like your credit card outstanding or personal loan outstanding. However small the outstanding maybe, repay these first because along with interest, they can accumulate to huge debts.
Step 4: Prepay, if possible, high interest loans
The decision of prepayment must be a calculated one. But there is a simple rule that will help you. If you suddenly land a lump sum amount of money and want to know whether to invest it or prepay a debt with it, compare the interest that you can earn from investing with the interest you have to pay on the outstanding. If interest earned is more than interest payable, then investing is a better option. But if it’s tough to get a return, which will beat the cost of the loan, then pay back! Remember to add any prepayment charges to the cost of your borrowing when you do this comparison.
Step 5: Substitute high interest loans with low interest loans
If you can borrow at low interest rates to repay high interest loans, then what are you waiting for? If you are running high debt on a particular credit card, find out a credit card that charges a lower interest rate and transfer your balance to the latter. Most of the time, the transfer can be done for free or you can bargain to waive transfer charges. Another alternative is a home loan top-up. Most banks offer a home loan top up to the extent of increase in security margins due to repayment of some part of the loan and also appreciation in property value. The home loan top up is given at an interest rate equal to the prevailing home loan rate, which is obviously very low. You do not need to tell the bank why you want the top up loan so borrowing is relatively easy. You may also want to borrow against your insurance policy since these loans will come relatively cheap. Substituting a credit card loan with a personal loan can also be a last ditch option.