Two strategies to avoid a debt trap during job loss and dwindling income

The avalanche will save you money, but the snowball approach is easier to stick to

The pandemic and the consequent loss of jobs and reduction in business incomes have led to an increase in household debt. According to a March 19 release from the Reserve Bank of India (RBI), the household debt-to-GDP ratio rose from 35.4 per cent in the first quarter of 2020-21 (Q1FY21) to 37.1 per cent in Q2. Add to that the easy availability of loans via apps, and the chances of falling into a debt trap are perhaps higher today than at any time in the past. If you are caught in such a situation, adopt one of the two strategies described below.  

Debt avalanche

This is the strategy most financial planners and debt counselors recommend. Here, you need to rank all your loans by interest rate—from the highest to the lowest.

Make minimum payments on all loans to avoid a default, which means you pay loan EMIs and Minimum Amount Due (MAD) on your credit card debt. Use the surplus you are left with to pre-pay a part of the debt that carries the highest interest rate. Mrin Agarwal, founder-director of Finsafe, says, “Typically, the interest rate on credit card debt is the highest, so pay it off first.”

Keep doing this till you have paid off your highest-cost debt entirely, then move to the debt with the next highest interest rate, and so on. After credit cards (which could carry an interest rate of up to 49.5 per cent) attack personal (9.35-24 per cent) and consumer durables loans. Using the avalanche approach, you will save more in interest cost and also pay off your dues faster.

Debt snowball

Under this approach, you pay off your debt in the order of smallest to largest balance, regardless of interest rate. Make the minimum payments on everything. With the money you are left with, focus on paying off your smallest debt first. When that is paid, move to the next smallest, and so on.

M Barve, founder of MB Wealth Financial Solutions, says, “This method is about getting small wins quickly. Debt is also a behavioural and a psychological issue, not just a mathematical one.” Researchers have found that focusing on paying down the account with the smallest balance tends to have a powerful effect on people’s sense of progress, and they feel motivated to stay on track.

The “tackle the easy debt first” approach is easier to implement. On the flip side, it is more expensive, and it may also take you more time to get out of your debt entirely with it.  

Which one should you opt for?

A desire to become debt free and being willing to work towards that goal is crucial. Pankaj Mathpal, managing director and chief executive officer, Optima Money Managers, says, “Purely from a cost point of view, the avalanche approach makes more sense as it saves you more money.” But if you tend to get discouraged easily and want to make the whole process easier to stick to, then Barve suggests using the snowball option.

Apart from debt, look up your investments too. Mathpal says, “If you have investments that give lower returns than the interest you pay on your loans, liquidate them and use the money to pay off your dues.”

Stop piling up more debt, then use one of the two strategies that suits you better. In addition, renegotiate with your current lender to lower rates, or consider a balance transfer. If you are unable to deal with things yourself, seek a debt counselor or a financial advisor’s help.

Tips for dealing with recovery agents

• Take down the recovery agent’s full name, his contact details, and find out if he  represents the lender or a third-party agency
• Record all conversations
• Inform the recovery agent you have full intentions of repaying your genuine obligations and that you are open to negotiating
• If the agent uses abusive language or threatens, calmly inform him that you will report the matter to the concerned authority
• If things get out of hand, hang up and get in touch with the lender
• If the threats increase, file an FIR against the chairman of the company that employs the recovery agent, and make the latter also a party