You are struggling with debt and are unable to keep up with monthly EMIs and card payments. And you have a bigger problem when your debt is spread across multiple loans or credit cards because you must manage multiple facilities. Tracking so many payments can be time-consuming. Plus, there is also a choice involved. The choice of which debt to prioritize for repayment. And this choice itself adds to the headache.
A debt audit can help you.
What Is a Debt Audit and How Can It Help?
A debt audit starts with compiling information about all your loans and outstanding credit card debt at one place. Thereafter, you use the info to manage and track your loan payments. If you are under stress, you can use this information to build a strategy to pay off loans or reduce debt.
Let us break this down as a multi-step process.
Step 1: Compile Information
Loan Name (you can assign a custom name. Home loan, personal loan, car loan, gold loan, TV loan, ICICI Credit card, HDFC Credit card, loan from friends/relatives etc.)
Lender/Bank name
Sanctioned loan amount/credit limit
Disbursed loan amount
Current loan outstanding/credit card outstanding
Interest rate for the loan
EMI/Minimum payment due (MAD) in case of credit cards. MAD can come into picture if you simply cannot pay in full OR if you cannot access cheaper mode of financing (such as a personal loan) to settle this in full.
Loan start date/Contracted Tenure (sanctioned loan tenure). Will be “NA” for credit cards.
Loan end date/Outstanding tenure. For credit cards, this will again be “NA”
Loan EMI debit date/Credit card bill date
Remarks: Any penalty, foreclosure charges, any contingent charges. Anything that may change the priority of payment/close.
Include all kinds of debt. From any source, irrespective of loan size.
It is important to add loans from friends/relatives too to this list. Such loans may have come with or without interest. The relative may not pester you for money. Still, such borrowings must be returned. You do not want these loans to affect your relationships.
You do not need any fancy software to do this. You can compile all this information in MS Excel or Google Sheets file.
Step 2: Quick Assessment about Your Cash Position
Do a quick comfort test.
Firstly, add up all the EMIs.
You can view this as a percentage of your net income. Calculate your own version of Fixed Obligations to Income Ratio. This will give you a sense if your debt obligations are manageable or are too high. Anything above 40-45% is a problem.
Note that loan EMIs may not be your only debt payments. Credit card payment will also add to your liability.
If, for a month or two, your credit card bill is huge, you may have a smaller problem to deal with. However, if you regularly rake up such high credit card bills, then you need to rethink twice. Either cut down on your expenses (the discretionary ones) or figure out a way to increase your income.
If you are neck deep in debt (loans + credit cards) and want to somehow attack debt by making minimum payments on some of your credit cards, you must use a different version of calculation for debt-to-income ratio. Add all the EMIs and the minimum amount dues (MAD) on credit cards and then divide by net income to arrive at Debt-To-Income (DTI) ratio.
Add all the EMIs and the minimum amount dues (MAD) on credit cards and then divide by net income.
Step 3: Strategize
There are 2 broad approaches to manage debt that is growing out of control.
- Debt Snowball: Pay off the smaller loans first. Pay off all the EMIs + Minimum payment on cards. Divert any excess savings to the smallest loans.
- Debt Avalanche: Pay off the most expensive loans first. Pay off all the EMIs + Minimum payment on cards. Divert any excess savings to the most expensive loan.
I have covered these strategies in detail in a previous post.
Please note paying off EMIs and making minimum payments on cards is important to avoid adverse credit reporting, becoming a defaulter in banks’ book and have recovery agents show up at your house. These points require due consideration, otherwise you may just focus on paying the most expensive credit card debt first. Remember, even in case of skipped EMIs, penal interest rate can apply which can increase the cost of loan sharply. Say, from 12% to 18%, if you skip an EMI.
Now, while debt avalanche may be a more appropriate approach for those who are mathematically inclined, you do not always have to execute the most optimal strategy. For many borrowers, a simple debt snowball may be a good and easy to execute strategy.
Imagine struggling with 10 different loans. Imagine the emotional comfort, psychological boost, and appreciation for discipline if you foresee that you can reduce the number of loans from 10 to 3 over the next 6 months. It is easy to stick with discipline when you can see that your efforts will bear fruit soon.
You might also want to consider factors such as penalties or foreclosure charges to pick a strategy. No right or wrong answers here. You can also use a mix of both.
The good part is that, once you have compiled all this information in an excel, it is just about setting up a filter.
- If you go with debt snowball strategy, sort loans by outstanding balance.
- If you opt for debt avalanche, sort loans by interest rate.
Step 4: Do Not Just Stop Here
Do this exercise (updating information) every month at the start of the month.
Also, note down how much you paid towards each loan in a fresh column every month. By adding these numbers up, you can also know how much money you have devoted to debt repayment every month. You want to do better each month.
This will bring in urgency, bring in a lot of purchase, and may encourage you to actively save more to repay debt faster.
And yes, while you are at it, use your credit card judiciously. You do not want all this effort to go down the drain due to frivolous spending.
A debt audit will help you understand where you stand, how manageable your loans are, and address the issues actively.