Debt Management: Types of Debts and Strategies

If you have ever felt the burden of debt on your shoulders, you`re not the only one. Many have experienced the harsh seas of loans and credit, sometimes losing hope. It doesn’t matter if it is a student loan you thought would be the gateway to your dreams, a mortgage for that cosy nook home, or the convenience of a credit card; debt is a financial story one can face in any phase of life.

In this chapter, we'll go over the debt landscape together. Sure, it is a complicated process, but using the proper devices and awareness makes it more familiar and easy to get used to. You'll learn how to balance your debts like the other aspects of your life.

Different Types of Debts

When it comes to debt, it's not all black and white. Some debts can be stepping stones to financial success, while others can lead you down a path of financial strain. Let's explore the different types of debts, distinguishing between 'good' and 'bad' debt, with examples to give you a clearer picture.

• Good debt

Debt, which is considered good, is like an investment. It entails financial commitments that better position you financially in the future.

• Student Loans: These are usually regarded as good debt. Why? Since education is an investment in your future. A student loan to go to college may result in a degree that brings in more chances of getting a better job and possibly a raise in income. 
• Mortgages: A mortgage is another instance of good debt in purchasing a house. Real estate normally appreciates in value over time, and buying a home is more advantageous than renting in the long run. 
• Business Loans: If you’re about to get a loan to start/grow a business, this is an investment. Here, the purpose is to bring in earnings and profits that are much higher than the cost of the loan.

• Bad debt

Bad debt, on the other hand, typically involves borrowing money for depreciating assets or non-essential items. It can lead to financial troubles if not managed properly.

• Credit Card Debt: This is often labelled as bad debt, especially when used for discretionary spending on items that lose value quickly. Credit cards usually have high-interest rates, which can compound the debt problem if balances aren’t paid off monthly.
• High-Interest Personal Loans: Loans with high interest rates for non-essential spendings, like vacations or luxury items, can quickly become financial burdens. They are like holes in your financial boat – the more you have, the harder it is to stay afloat.
• Payday Loans: These are short-term, high-interest loans that are typically used to get through to the next paycheck. They can be a debt trap due to their extremely high-interest rates and fees.

Identifying the Dangers of Excessive Debt and Its Consequences

Let's simplify the concept of excessive debt and its impact. Imagine you're trying to fill a bucket with water, but the bucket has a big hole in the bottom. No matter how much water you add, it keeps leaking out. This is similar to how excessive debt works.

Say you earn ₹30,000 a month. If you're paying back ₹15,000 towards debts, half of your income is already gone. This leaves only ₹15,000 for everything else – rent, food, savings. It's like trying to run your house with half the resources you actually need.

Imagine you have a credit card debt of ₹50,000 with an 18% annual interest rate. If you only pay the minimum amount each month, you'll pay much more than the original ₹50,000 over time, and it will take years to clear the debt. Doesn’t look like an exciting picture, does it?

Having too much debt on your plate can cause a lot of worry and trouble. The consequences are dire, and some of them include: 

• Stress and anxiety result from constantly worrying about pending debts. 
• If most of your monthly income goes towards fulfilling debts, you’ll find yourself struggling to save for emergencies or future plans. 
• High debt can also lead you to miss out on many financial opportunities. For instance, you might not be able to get a loan for a new business idea because your debts are too high compared to your income.
• In the worst-case scenario, too much debt can lead to bankruptcy. Needless to say, it can have long-lasting effects on your ability to borrow money in the future.

To avoid these risks, it's important to manage debt wisely. Don't borrow more than you need or can comfortably pay back, and always keep an eye on interest rates and repayment amounts. Think of debt as a tool – used correctly, it can be helpful, but if misused, it can cause problems.

The next natural question that must arise is how to assess one’s financial health. Let’s look at exactly that in the next section. 

Debt-to-Income Ratio: A Way of Accessing Financial Health

Your Debt-to-Income (DTI) ratio compares your monthly debt payments and your monthly income. Showing the lenders and yourself how much of your income is taken by debt obligations is an important parameter.

Here’s how you can do the basic debt-to-income ratio calculation: 

• Add Up Your Monthly Debt Payments: This includes your monthly obligations such as loan EMI, credit card payments, and other loans.
• Determine Your Gross Monthly Income: This is your gross pay.
• Calculate the Ratio: Divide the total monthly debt by the gross monthly income and multiply by 100, resulting in a percentage.

Imagine your financial scenario looks like this:

• Monthly income (pre-tax): ₹50,000
• Monthly debts: ₹20,000 (Home loan EMI: ₹15,000, Car loan EMI: ₹5,000)

Here’s how you’d calculate your DTI:

DTI = (Total Monthly Debts / Gross Monthly Income) * 100

So, for your case, DTI = (20,000/50,000)*100 = 40%

What does this mean, and what does it say about your financial health? In simple terms:

• A DTI of <20% is considered excellent. It means a very small chunk of your income is going for debt repayment. 
• A DTI of 20%-40% is considered manageable and comfortable – but you should be cautious about taking more debt. 
• A DTI > 40% is where you need to be really careful. You need to think about and manage your debts better because a significant portion of your income is going towards debts! 

So, how do you go about managing debt? Let’s look at some insights! 

Strategies for Debt Management

Here are some effective debt management strategies to give you back your control of finances: 

1. Creating a debt repayment plan

A debt repayment plan involves listing out all your debts and devising a structured approach to paying them off. Here’s a brief guide on how you can go about doing this: 

• Start by writing everything you owe – from the smallest credit card bill to the biggest loan. 
• Then, focus on high-interest debts first, simply because they will keep increasing quickly with time. This method has been called the “avalanche method” if you’re interested in terminologies! 
• Always set realistic repayment goals. Figure out how much you can realistically pay off while having your monthly essentials covered. 
• Keep tracking and adjusting your plan if your financial situation suddenly changes. 

2. Utilising debt consolidation strategies

This is about combining several debts into a unified debt – usually with much more favourable payoff terms. There are a couple of ways you can go about doing this: 

• Take a new loan to pay off various previous smaller debts. This way, you would simplify your payments and potentially reduce your interest burden. 
• If you have credit card debts, you could transfer balances to another card with possibly a lower interest rate. Some cards even offer 0% interest as introductory offers. You could check those out! 

3. Exploring options for debt relief

Sometimes, the debt burden can be overwhelming, and you might need external help to navigate through it. Try and:

• Contact your creditors to see if they can offer more favourable repayment terms. 
• Settle the debt by paying a lump sum that is less than the full amount you owe. This has its disadvantages, but it does get you out of a significant debt. 
• Consult a credit counsellor or financial advisor for personalised advice, suggestions, and possibly debt management plans. 

We said that settling the debt comes with some disadvantages. Well, one major disadvantage is its negative impact on your credit score. If this makes you more confused than earlier, you probably don’t know what credit scores are and how they’re determined. Let’s ease you out! 

Building Credit and Credit Score

Think of your credit score as a financial report card summarising your creditworthiness. It's crucial in determining your access to loans and credit cards and even influencing the terms and interest rates you're offered for any future loans or EMIs you may need.

A high score can open doors to better interest rates and terms on loans and credit cards, potentially saving you a lot of money over time.

Here are some of the factors that go into determining your credit score: 

• Payments history
• Amounts owed
• Length of credit history
• Credit mix
• New credit

So, how do you build your credit score? Here’s how: 

• The golden rule – always pay your bills on time. Think of it like submitting your course assignments on time and the negative consequences that can follow if you fail to submit your assignments on time. It’s pretty much the same. 
• Keep your credit card balance low relative to your credit card limit. 
• Avoid taking more loans than you can handle or maxing out your credit cards. 
• Don’t let your bad credit history go on for too long. 
• Limit applying for new credit cards frequently. 
• Regularly and carefully check your credit reports for errors. Catching these errors beforehand is better than letting them blow up! 

Now that we arrive at the end of this chapter remember that controlling debt is the key to financial stability. It's about understanding and controlling various kinds of debt, being cognizant of the risks of borrowing too much, and having a sound debt-to-income ratio. 

These two tools, effective debt management strategies and a good credit score, play a big role in your finances. Look at them as travelling companions on the road to financial wellness. You're now ready to deal with the financial world with a good understanding of the landscape and ready to achieve your long-term dreams. Cheers to a financially rosy future!