One of the biggest challenges most people have is the looming amount of credit card, overdrafts and personal loan debts built up over the years. With balances up to RM10,000 at 20% interest, they find themselves paying more than RM500 per month in interest expense alone, never able to reduce the principal balance of their debt, which adds up to more frustration and pain.
So, what do you do if you have outstanding debt of RM10,000 and you want to settle it in two years? Having significantly less debt allows you to save up for a house down payment or marriage. Putting these principles into practice will enable you to take better control of your finances and reduce your debts.
Prioritise your debt
When you have more than one debt to pay, it would be rational to pay off the debt with the highest rate of interest. Avoid “negative amortisation” where you begin paying interest on interest you already owed because you didn’t make enough payment to reduce the balance. This is why it is important for us to pay off high interest incurring debts first. Or else, we could be paying twice the original amount.
However, also consider what you stand to lose for non-payment. Priority debts should also be those that have fairly dire consequences if you don’t pay. For example, you may lose your home if you default on your mortgage payments, get blacklisted and barred from leaving the country for missing your PTPTN loan repayments, or have legal action taken against you for outstanding credit card debts.
People with more financial discipline can get ahead more quickly by paying off the credit cards and loans with the higher interest rates first. This will minimise costs to become debt-free faster than the smallest-balance approach.
Pay off the lowest debt balance first (the Snowball Technique)
The above is best applied if you have the discipline and willpower to do so. If you are not as disciplined or savvy, the snowball technique will help you manage your debts better and will also have a positive psychological effect in seeing your bills reduced.
Start by listing down your debts from the lowest amount to the highest.
For example, let us assume you have allocated RM500 monthly for debt repayments. If you add up the minimum monthly repayments of all the debts, it sums up to RM386. This means you have an extra RM114 to contribute towards paying off the debt with the lowest balance (i.e. Credit Card A). Instead of paying the minimum RM50, you pay RM164 (RM50+RM114).
Continue to bring forward the extra money once you have paid off each debt (starting from the smallest). Repeat this process until you are left with your single, biggest debt.
* Amounts stated are the average sum, as the monthly payment may differ.
** Interest amount is not included in the calculation to simplify the example.
This practice is known as “snowballing” in the financial planning industry because the amount of money you send in to each payment gradually snowballs as each debt is reduced until you are sending in large amounts of cash to pay off your biggest and final debt. It is similar to rolling down a snowy hill, forming a snowball. The snowball will grow larger and faster as it rolls further down. The snowball technique helps to repay your high interest balances far faster than you could by just using a random payment arrangement.
Make micro payments to reduce debt (the Snowflake Technique)
The snowflake technique is designed to help you pay off your debt by making micro payments. These payments can start off from a small amount and over time add up to big balance reductions, which can potentially save you thousands in interest expense.
Every time you gather some funds, regardless of the amount, use it to pay off your outstanding debt payment. If you were to keep the amount, you would most probably spend it on something else that is unproductive. This is completely normal behaviour, as there are many things in life that an individual would want.
People often ignore the power of small amounts. Your small efforts may not look like they’re even putting a dent in your debt, but there is a compounding effect that is at work. Over the years, your debt will be eventually paid off. With RM10,000 to be settled in two years, you need to be paying approximately RM14 daily, doesn’t sound that bad now does it?
To complement these three methods, you can clear your debt faster if you take up some of these financial principles:
Use your credit card wisely
When your credit card statement comes and you are not able to pay off the entire balance in full, you have well exceeded your resources. Understand that a credit card merely allows you to postpone the date of your payment, but not the payment itself.
Only use your credit card if you already have the funds available or will have it available within a specified period of time. Be careful about unnecessary spending, especially ones that supersede your budget or resources.
Procrastination is the enemy
It is advisable to make debt repayments diligently before the due dates instead of falling behind. If you seem to always pass the due date and end up paying more interest, work on setting reminders on your calendar, on your phone, or get your spouse or friend to remind you of it. This is so you can avoid incurring higher interest on your payments.
Pay extra whenever you can
Whenever you receive extra funds from a bonus, work claims, or side gig, increase your debt repayment amount. By doing so, you can reduce your debt faster. You don’t have to sacrifice all of your extra income, but every little bit helps.
Plan baby steps in paying off your debt
You can start off with a low repayment plan in the beginning years and later increase it as you progress with a promotion or higher remuneration. For example, by just making the minimum payment for a RM20,000 debt on a credit card with an interest of 17%, would cost RM7,274 in interest charges and will take you six years and four months to clear.
Having a well planned repayment strategy will allow you to make better financial decisions when you spend and repay your debt.
Note: Interest amount is not included in the calculation to simplify the example.
Sell your lower-yielding investments
If your investments are only yielding you an investment return of only 5% but the interest rate you are paying for your debt is 10%, then it is almost always a better choice to sell those investments to pay off your debts instead.
Reduce your savings if you have debt to pay
Saving money is key to expanding your finances. However, there is such a thing as saving too much. It is not financially wise to hoard your money into a savings that yields a maximum of 3% interest returns over a debt that is charging you a higher interest rate of maybe 17%. Yes, it is important to build up enough savings to protect yourself against unforeseen future emergencies. However, if there is a significant difference between the interest gain and interest paid, you may as well use the funds to pay off your debts instead.
See where you can cutback
The golden rule of any financial advice is to work out a budget. Draw up a budget including not only your income versus expenses, but also your debt repayments. Having a budget will enable you to identify the spending that you can cut or control. In the process, you will acquire a more disciplined and responsible attitude towards your finances.
The goal of taking control of your finances is to increase your cash flow each month. The more excess money you have, the more you have to reduce your debts. But, always remember, your monthly debt payments should not exceed 36% of your gross monthly income.
This article was first published in August 2014 and has been updated for freshness, accuracy and comprehensiveness.
Read More: Should You Be Debt-Free Or Free Of Bad Debt?