What should be your first step before you get down to creating your financial plan? Some may say defining your goals and some may talk about planning your investments. But financial planning actually begins with managing your loans or your debt. Managing your loans is not just about reducing your debt but about managing your debt. You need to prioritize your goals in such a way that your debt is taken care of properly.
Debt management is a way to keep up with your bills, especially if they have seemingly gotten out of control. You can use many strategies to manage your debt, including the debt snowball method or working with a credit counseling organization.
Let us also understand debt management from the prioritization point of view. Here is how to go about it and also why it is important.
Table Of Content
- Understanding Of Loan & Debt Management In Personal Finance
- What is Debt Management?
- How does debt management work?
- Key Features For Debt Management
- Does debt management affect your credit score?
What is debt management?
Debt management is a way to get your debt under control through financial planning and budgeting. The goal of a debt management plan is to use these strategies to help you lower your current debt and move toward eliminating it.
You can create a debt management plan for yourself or go through credit counseling to help you with your plan. Both ways have advantages and disadvantages. Setting up a plan yourself is the simplest way forward, but sometimes it can be helpful to have an outside partner providing help or accountability.
How does debt management work?
Debt management plans address unsecured debts like credit cards and personal loans. Debt management usually happens in one of two ways.
Credit counseling companies offer all kinds of ways to “help” you get out of debteverything from debt management plans to debt management alternatives like debt consolidation. So you have to keep your eyes wide open, because these companies will to try to sell you their services as the “best” or “only” way to get your debt paid off.
But when it comes to DMPs(Most debt management programs), it all boils down to these 3 steps:
- 1. Meet with a credit counselor: Most debt management programs have credit counselors who work with nonprofit agencies (although there are some for-profit agencies out there too). They’ll act as the middleman to negotiate lower interest rates and fees for all of your unsecured debt and help you create a plan to pay it off.
- 2. Pay off your debt (with help): Now that you and your credit counselor have created a plan of action, it’s time to pay off your debt. But instead of paying your creditors directly, you’ll pay your credit counselor, and they’ll do the dirty work of paying your bills for you. So, to you, it’s one nice lump payment plus fees for the setup and monthly maintenance, of course.Look, working with a debt management plan isn’t the silver bullet you’re looking for. In fact, it’s not a silver bullet at all. Why? Because it doesn’t address the core problem: the habit of relying on debt to cover expenses instead of creating and sticking to a monthly budget. No matter how you decide to deal with your debt, it’s going to take hard work, patience and time. Lots of time.
- 3. Create a debt management plan: Your credit counselor will help you create a debt management plan with the hope of paying off your debt in three to five years. How? Again, by negotiating with your lenders to get lower interest rates and waived fees. Some credit counselors are able to negotiate dropped late fees too. The idea of a DMP(Most debt management programs) is that by “saving” money on interest and fees, you’ll be able to catch up on payments and pay off your debt faster. Every debt management plan is tailored uniquely to your financial situation and how much negotiating your credit counselor is able to do on your behalf.
The Key Features Of Debt Management
- 1. First get rid of high cost debt
They are the actual drag on your finances. When you are running your credit on revolving credit by paying just 5% of the outstanding, then you are paying a huge cost of 3% per month. That adds up to nearly 38% on an annual basis. If you pay 38% interest on loans then there is no way that you are going to ever generate wealth on your portfolio. Whatever you earn will only be sufficient to pay your debt. Whatever surplus you have or whatever you can generate from capital gains, use to pay off debt classes like credit cards or personal loans.
- 2. Debt management with a credit counselor
The second form of debt management is through credit counseling. You can find a credit counselor in your area through the National Foundation of Credit Counselors. There are both nonprofit and for-profit credit counselors. Read reviews and understand any fees you might be charged before signing up for a credit counselor.
A credit counselor will help you come up with a plan to repay your balances and can negotiate a debt management plan (DMP) with your creditors if necessary. It usually spans three to five years and includes concessions, like a lower interest rate, reduced monthly payment or fee waivers, to help you get out of debt faster. Depending on your circumstances, the creditor may close your accounts as each debt is paid off to avoid creating any new debt.
- 3. What about home loans where tax shields are diminishing?
Home loans offer you two kinds of tax shields. In India There is a tax exemption up to Rs.2 lakh on the interest component and then there is also an exemption under Section 80C on the principal component. Normally, the interest component on the home loan is higher in the initial years and then starts falling in later years. At that point if you get surplus cash with you, it can be seen as an opportunity to close your home loan. There is no point in continuing your home loan when the incremental tax benefits are limited and you can use the EMI component to make a more worthwhile investment. Alternatively, if you find that that the apartment is giving you negative equity then it is always better to close out the loan as you don’t run the risk. Once you have closed the home loan you can look at what is to be done with the property
- 4. You can also look to restructure your loans on more favourable terms
A good credit score and a good relationship with the bank can be quite valuable in a variety of ways. For example, if you are having too many small loans, you can approach your bank to consolidate these loans into a single loan to make servicing easier. Alternatively, you can also look to extend the tenure of the loan to reduce the EMI and put lower pressure on your finances. These don’t have any standard model but you can sit across the table and negotiate with the bank.
- 5. Regarding the other loans, try to negotiate your way through
Quite often there are other loans like car loans, gold loans and home loans. What to do with these loans. Obviously you want to hold on to home loans as the tax benefits are quite valuable to you. What about your car loans? Car loans typically have negative equity because the value of the car comes down by at least 30% the moment it is driven out of the showroom. That means at any point of time the value of the loan is always higher than the market value of the car. If you get an opportunity to close the car loan, you can bargain with the bank for zero prepayment charges and close the loan.
Does debt management affect your credit score?
While debt management can be a helpful tool to get debt under control, it can negatively affect your credit score.
- Credit utilization
Another key factor in the health of your credit score is your credit utilization. This factor makes up 30 percent of your calculated score and is linked to how much debt you carry compared to your available credit. The ideal credit utilization is between 10 and 30 percent. This means that your debt should equal no more than 30 percent of your available credit across all accounts.
Having all your debt consolidated into one bill can be beneficial for paying things off. However, if you close some of your accounts, you’ll affect your credit mix, which makes up 10 percent of your credit score, and your credit history, which accounts for 15 percent.
- Hard inquiries
A hard inquiry may happen at some points in debt management. For example, if you attempt to get a lower interest rate, you may trigger a hard inquiry into your credit report. Hard inquiries stay on your credit report for two years and can impact your credit score for one year.
However, this is a short-term effect and can easily be countered by other factors. For example, if you can get your rate lowered, and this means you’re able to pay your monthly bill consistently, you’ll see a positive effect on your payment history, which makes up 35 percent of how your credit score is calculated.
- Missed payments
While consistent payments will positively affect payment history, missing payments will cause your credit score to lower significantly. If you, or your credit counselor, are using a tactic of withholding payment from your creditor to get a better rate, expect your credit score to go down.