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Which debt to pay off when you have more than one loan?

Posted on 19 Jun 2021
Author: Sayan Sircar

Tags: Loans

7 mins read
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We discuss the two common debt payment methods that exist which can be used to easily pay off multiple loans: the avalanche and snowball methods.

Debt payment via snowball and avalanche

This article is a part of our detailed article series on the concept of paying off loans. Ensure you have read the other parts here:

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My EMIs take up all my salary. How do I start investing?

This article shows a few ways to avoid and escape from EMI traps to be able to invest via goal-based investing.

📚 Topics covered:

1. Avalanche method
2. Snowball Method
Source of funds for debt payment [^{Ref 1}]
Next steps for future

If you have two or more loans, there are two strategies to pay them off. In general, all loans require a minimum payment every month called EMI. This article deals with what to do with any extra cash available every month for loan payments. The methods below differ regarding the choice of the loan for that additional payment. Once one loan is closed, the entire EMI gets split among the remaining loans.

Budget Waterfall

Debt payment is part of handling overall budgeting that should be read together with

List of loans

For example, if the minimum EMI is 70,000 and the extra cash is 10,000/month, then every month 80,000 will be paid until all the loans are closed. If extra cash is not available, even then use the same concepts with 70,000/month once the first loan is paid off.

📚 Topics covered:

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1. Avalanche method

The strategy is to take the loan with the highest interest rate, like a credit card balance or personal loan, and pay it off as much as possible every month while making standard EMI payments on the rest.

This strategy minimizes the interest being paid and also leads to the least time to pay off all loans. It is suitable if you can be patient with the repayment plan knowing that you will be paying lesser interest overall.

Using the example above, the interest paid is 7.5 lakhs over 57 months.

The debts are paid off in this sequence:

Credit card (highest interest rate)
Personal loan
Education loan
Home loan (lowest interest rate)

2. Snowball Method

This strategy exists so that the borrower can feel a sense of accomplishment and relief by getting rid of the loan with the lowest outstanding balance first while making standard EMI payments on the rest. The extra payment goes to the loan with the smallest balance without regard to the interest rate.

Once that loan is closed then the process is repeated with the rest of the loans. This strategy gives relief to the borrower struggling with a lot of loans. This method will lead to higher interest payments and a slightly longer overall payment period compared to the avalanche one. This method works if you like to see results earlier than the other plan and can get a psychological boost to see the count of loans reducing.

Using the example above, the interest paid is 8.2 lakhs over 58 months.

The debts are paid off in this sequence:

Education loan (lowest starting balance)
Credit card
Personal loan
Home loan (highest starting balance)

Like everything else, there is a middle path between these two extremes:

Here you pay off the highest-interest loan first and this is best if it is something like a credit card balance with high interest rates.

For the rest, approach a loan consolidation agency to combine the loans into one single loan with one EMI. If consolidation is not possible, then choose between the avalanche and snowball methods as per your personal choice.

If you have multiple credit cards with rotating balances, then it will be better to pay off the one with the least balance first in case you need to use credit cards in the future for any emergency. This works since the freed-up card will not charge interest from day one for the older debt.

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Source of funds for debt payment [^{Ref 1}]

Investments apart from the emergency fund

Apart from emergency funds, any investment or asset like stocks, mutual funds etc can be considered to pay off the loan especially if it is a high-interest one like a credit card. Typically stocks and mutual funds will not give a guaranteed 40% return which is the typical rate of credit card loans

A new line of credit

Approach your home loan provider (if you have one) for a top-up loan. This will be at a rate lower than the credit card and personal loan and good for those with some history of paying off home loan EMI on time. Alternatively, a personal loan can also be taken to pay off the higher-interest loans.

Matching payments

If you are helping out a relative or child with debt payments, offer to match their debt payment in the same amount. If they are paying ₹ 5,000/month, then you can also pay the same amount. If, however you offer to pay off the whole debt, it creates a situation where you will be considered a source of future bailouts also.

Next steps for future

Divert any available income from expense cuts, selling off unnecessary stuff or even a bonus at work towards an emergency fund. This builds a cushion to avoid future high-interest debt like credit cards used for emergencies.

Note: We have already covered home loan pre-payment here separately since the loan is of long tenure, it might be prudent to weigh the concept of pre-payment against investing for long-term goals.

Debt payment is one of the axioms of personal finance?

References:

Ref 1: How to get out of Debt?

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