How to manage high-interest debt in an increasing interest rate environment
Globally, central banks are expected to increase interest rates for the coming year. Countries like the United Kingdom, South Korea, New Zealand, and Brazil have already raised their interest rates for 2021. The US had recently increased its interest rates from near zero to a range between 0.25% to 0.5% with the intention to raise its rates further by the end of 2022. 😯 So how does that affect you and how can best you prepare?
An increased interest rate obviously comes with higher debt repayment. Think of your car, mortgage, and credit card debt repayments increasing! If you’re living paycheck to paycheck, all the more you’ll need to pay attention. 😉
If you’re familiar with the highly popular personal finance book Rich Dad Poor Dad, then you would have likely come across common terms like “good debt” and “bad debt”. Good debt is a debt taken when it’s used to finance purchasing assets that put money into your pocket. Bad debt is a debt taken when it’s used to finance purchasing assets that take money out of your pocket. The most common bad debt you’ll want to refrain from is high-interest rate debt.
If you’re unsure what a high-interest rate debt is, it’s any debt with an interest rate of over 7%. That is usually the case for credit cards and for some, it might be student loans. See here if you’re curious why 7% is the magic number! If you’re feeling queazy just from knowing that your expenses are increasing, worry not! Here are ways to manage it or even better, get rid of high-interest debts!
1. Create a budget
If you’re clueless about where all your money went at the end of every month, this indicates that you’ve not been tracking your expenses and knowing your limits to spending. Not knowing how much you can afford to spend is the easiest way to fall into the trap of emotional spending. Have you ever thought of “buy now, think later”? Well, it’s the first step to getting yourself into credit card debt. So how do you go about creating a budget? (See here to know how I did mine!)
i) Audit ➡ Look at your credit card statements, loan repayments, and expenses. List down all your bills and expenses and categorize them into necessities, education, contribution, play, long-term savings (big-ticket items), and retirement.
ii) Look at account balances ➡ List down all your income, side-hustle income, cash backs you’ve received and sum it all up. Look at the totals of your debt repayment and income. Does your debt repayment exceed your income? Or vice versa? If your debt repayment does exceed your income, you’ll definitely want to read on!
iii) Set money goals ➡ Setting aside money goals helps you fulfill your own needs as well without breaking the bank. It does not mean that you can’t have it but wait to have it instead. Want to buy the latest gadget? Set it as a money goal! (After you’ve paid off your high-interest rate debts, of course!)
iv) Optimization ➡ Have you been setting aside financial matters that are not a priority to you but would like to make it a priority? For example, filing your taxes or reviewing your financial position, or estate planning. If placing a standing order to avoid getting further into debt is the current priority, put it as the top priority of your budget planning.
2. Avoid adding purchases with a credit card
To make sure that you’re not caught up in spiraling debt whereby credit card interest is known to have high-interest rates compounded, voluntarily suspending your credit card purchase is the best way to curb it. Instead, use cash or debit card. Placing a standing order on your account for recurring loan repayments such as credit card, mortgage, or car on the day your salary is credited is the easiest method to ensure that you don’t overspend but what’s leftover.
3. Debt Avalanche Method
This is IMO, by far the best method that helps to accelerate paying off your debt and pays the least amount in interest especially when interest rates are rising. A debt avalanche method is a repayment method that involves paying the minimum amount on all debts’ outstanding balance and then using any money leftover to pay off the bill with the highest interest rate.
For example, if you have an additional $2000 leftover for debt repayment every month and have an outstanding credit card debt of $10,000 with an 18% interest, a student loan of $16,000 at 8% interest, and another credit card debt of $5000 with a 12% interest, you would have to start paying off the debt with the highest interest followed by the next highest interest until all high-interest debts are paid. So, by following the avalanche debt repayment method, you would have to pay the minimum amount for all debt and start paying off your first credit card debt with an 18% interest from the $2000 you have leftover every month until it’s settled. Then, continue the process again with the 2nd credit card debt with a 14% interest until it’s paid off and finally the student loan.
With the debt avalanche method, you would have easily saved a whopping $109, 494 in interest and become debt-free from high-interest rate debt 647 months sooner! 😮
4. Debt Snowball Method
While the debt avalanche method makes the most sense to save on interest, some might argue that a debt snowball method makes it psychologically more pleasing to stay on repaying your debt — especially from well-known personal finance experts like Dave Ramsey. It’s because a debt snowball method differs slightly from the avalanche method simply by paying off the debt which has the highest outstanding balance instead of the highest interest. So, obviously, it makes it more motivating for one to settle off the “easiest” loan instead of staying on for a long time to tackle the loan with the highest interest especially if it has the biggest outstanding amount. The solution? Place a standing order if you’re not disciplined enough to stay on track.
If the previous example were to be used in a debt snowball method instead of a debt avalanche method, you would have been able to save an enormous amount as well of $109,365 in interest and become high-interest rate debt free 647 months sooner as well. The difference? You’ll be able to pay $130 less in interest for using the debt avalanche method.
5. Use balance transfer or debt consolidation loans
If your credit score is still feasible to take on another loan or credit card, the usage of a balance transfer to a credit card that offers 0% interest rates (usually during a bank’s promotional period to acquire customers for credit card) or debt consolidation loans are one of the fastest and easiest ways to settle high-interest debt. Debt consolidation loans generally have lower interest rates than credit cards and are much easier to manage as they have a fixed payment amount and an agreed timeline to settle off the loan. Nevertheless, it’s just as important to settle your loan as soon as possible so you would not need to worry even when interest rates are increasing.
While the majority of us don’t like debt especially when it’s due for us to start making payments every month, it’s just as important to know how we got into debt in the first place. Could it have been avoided? Was it due to emotional spending? Or was it due to family commitments? Or medical expenses? Regardless of the reasons, it’s crucial to solve those problems first to avoid spiraling into debt again. Otherwise, these suggestions might not be able to serve justice. I hope this could give you a guideline on how to get out of high-interest rate debt!
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