When it comes to debt - one group will exclaim that we should not even get close to it.
Another group will use debt as a way to live like rich Jones.
If one stuns our growth, another will totally destroy us.
So its very important for us to know when to get a loan and when not to.
That is, we should know what is a good debt and what is a bad debt.
I can hear you saying, "What good is there in a debt?"
True. But in our life, we can get loans if necessary for our future growth. There is nothing wrong doing that.
So then, how can we tell the difference between good loans and bad loans?
How can we get out of a bad debt? That is what this episode is about.
Any debts that help with our financial growth are good debts.
Any debts that hinder our financial growth are bad debts.
Lets take education loan.
We should not hesitate to get a loan for that.
That too for a degree in STEM - Science, Technology, Engineering and Math.
For getting these degrees, if we don't have money in hand, we can definitely get a loan for that.
This is a good debt.
My life itself is a good example for this.
When I came here to US for doing MS, I was in need of Rs. 4 Lakhs.
I got that thru an education loan.
If I have hesitated to get a loan at that time, I would not have been here.
Not necessarily for a college education, but even for a personal development,
if that is going to make a big difference in our life, then it is totally OK to get a loan for that.
Other than these, are there any other good debts?
Lets look at another example. Lets say that I know a strategy to make money.
That strategy could be an investment or a business idea.
Lets say that I can reliably see a profit of 20% from that.
That is, for a Rs. 1000 investment, if I can reliably see a profit of Rs. 200,
then I can get a loan for that Rs. 1,000.
But the interest that I can pay for that loan should be less than 50% of the profit.
That is, if I am expecting a return of 20%, then my interest should not go over 10%.
In our example of Rs.1000, if our profit is Rs.200, then our interest should not go over Rs.100.
As long as we are paying 50% or less of the profit as interest, this is a good debt.
If it goes above that, it becomes a risky debt.
When the interest goes over the profit from the loan, this becomes a bad debt.
So we need to be aware of this when we get a business loan.
If we get a loan thinking that it is a good debt and if that turn out to be a bad one, then it will result in digging our own grave.
Now lets see about bad debts.
Like I already said, any debt that do not help with our growth is a bad debt.
Among them, the worst is Credit Card debt.
Most of them who are in credit card debt, might not have got in there for buying necessary things.
All would have been for consumption expenses - like buying luxury items like TV, phone, sofa etc.
Many get stuck in this credit card debt without knowing its seriousness.
Especially the International students in America, Australia and new earners,
they are like gods for the credit card companies.
Because, they are all the ones who are over confident and get into credit card debt without knowing its long term impact,
as they are proud to get access to that much money.
Very soon, they will realize the seriousness of it. But by that time, it would have been too late.
It takes many years for them to get out of that debt.
The phase in which, they should have saved a lot and invested for their future growth, they waste it away by paying that growth to the credit card companies.
I have seen personally many of my friends who came here to US for doing MS went thru this.
So - use credit card only if you can pay off the full balance every month.
If you dont have that control, throw away the credit cards and learn to use just cash.
It is very easy for us to swipe away the credit card.
But if we have to open up our wallet for paying, then we would ask the question of, if this expense is absolute necessary?
So if you are a limitless spender, switch to cash.
Not just for you, it will be a big help for your whole family.
OK. Credit card debt is a bad debt. How about car loan?
That depends on the reason for buying the car.
If our business needs a car,
and if we buy for that, then it becomes a needed expense. Good debt.
We have to go to then office, but there is no public transportation.
Car is the only way to get to the office - then the car loan is a good debt as well.
But when that need is served well by a Maruti car,
if we buy a Corolla for higher loan amount, then it is a bad debt.
Many make this mistake.
For them, car is an asset.
They do not know the truth that is not an asset, but a liability.
I myself have done this mistake.
When I joined for my first job, I did my second MS in part time.
I needed a car to get to that campus.
So I was in a situation to buy a car.
I should have bought a simple car for $3,000 to $5,000.
But for the knowledge I had at that time,
I bought the car for $12,000 - with $7,000 in loan.
The expense did not stop there.
Because I was younger than 25 years,
and also because I have just got the license, I had to pay $600 for car insurance.
That reminds me of how ignorant I was at that time.
We live and learn.
How about a house loan? Is it a good debt or a bad debt?
That depends on how much interest we are paying and how much the house appreciates.
Generally speaking, it is a good debt.
In US, house loans are very cheap.
So if we buy a home, not like a mansion but for our needs, then it is definitely a good debt.
But because the home loans are expensive in India, we will not be able to say that it is a good debt.
We can say that it is in the borderline between good debt and bad debt.
All that is OK - but how can I get out of a debt that I am already very deep in?
There are 2 strategies for that.
First is logical approach - Debt Avalanche strategy.
Second is psychological approach - debt snowball strategy.
Regardless of which strategy we are going to follow, we have to do two things first.
1. Until we pay off the debt, we have to live like a himalaya saint.
There should not be any expenses other than the absolute needs.
Cut off cellphone, Cable TV, Newspaper
Live as simple as possible.
The next thing we have to do is to see if we can increase the income in any other ways.
Like tutoring students in the evening.
If we do these two, we should be able to increase the monthly amount that we can use to pay off the debt.
Lets see how we can use these two strategies with an example scenario.
Lets say that we have 3 credit card debts.
First card has 2 Lakhs balance. 20% interest.
4000 minimum payment.
Second card has 1 Lakh balance, 15% interest and 2000 minimum payment.
Third card has 50,000 balance, 17% interest and 1000 minimum payment.
Lets say that we can spend upto Rs 20,000 for paying off these debts.
Normally people just allocate random amounts to each of these debts every month for payment.
We should not do that. Logically we should target the one with the highest interest rate and pay that off first.
That is what is called as Debt Avalanche strategy.
Avalanche is - snow, ice and rocks coming down from ice mountain in great rush.
Like in Bahubali movie.
Because the debts are paid off with the same rush, it is called Debt Avalanche strategy.
Now you know why I said that we have to live like a Himalaya saint for paying off a debt.
In our example, the 2 Lakhs debt has the highest interest rate.
20%. So we should target that first.
Paying the minimum payment for the other two debt, we should use the rest of the money to pay off this debt.
What we are seeing here is, the debt calculator in calculator.me site.
I have entered our example here.
We should enter the first targeted credit card as the first entry here.
As debt avalanche strategy targets high to low interest,
first entry is 20% interest, second entry is 17% interest and the last entry is 15% interest one.
Here at the bottom, we should enter the rest of the money available other than the minimum payments for each card.
For our example, we have planned for Rs. 20,000
So other than the total minimum payments 7,000, we should enter the 13,000 here.
Now lets click on "Calculate Results".
Before checking the results, lets check out our payment schedule by clicking this "Create Payment Schedule" button.
So for our example, we have to the minimum payment of 2000+1000=3000 to the second and third credit card.
We have to pay the rest of the 17,000 to the first credit card.
We would have paid off the first credit card by the end of 14 months.
Next we have to target the second highest interest rate card.
For this, we will be paying Rs.18,000 monthly.
We would have paid off this one in 2 month, by the end of 16th month.
Next we are left with only one balance and we would have paid that off in 21st month.
So by using this Debt avalanche strategy, we would have paid Rs. 56,000 as interest.
Moneywise, this is the best strategy.
Because only this, we would have paid the least possible interest.
But psychologically this is not a good strategy.
Because it takes 14 months to pay off the first debt.
So the chances of dropping this plan in the middle is high.
That is why many recommend the debt snowball strategy.
Snowball effect is - if the himalaya saint drops a small snowball from the top of the mountain,
when it comes down the slope it would have grown bigger by collecting more snow.
It will come down as a huge snowball.
The idea of this strategy is to start the debt pay off small and finish it off with big
So in this debt snowball strategy, instead of targeting the debt with highest interest rate, we should target the one with lowest balance.
In our example, we should be targeting the third debt for Rs.50,000
Lets put this debt at the top in our calculator.
The second big debt, 1 lakh should go as second entry.
The biggest Rs. 2 Lakh debt should be third entry here.
Lets check the payment schedule now.
Because we are targeting the 50,000 debt, we should pay the minimum payment for the other 2 debts and pay 14,000 towards this debt.
We would have paid it off in 4 months.
When the 3 debt becomes 2, it gives a psychological boost for us.
We should carry that momentum in paying off the second highest 1 lakh debt.
We should be able to pay it off in next 7 months.
We should be able to pay off the last debt in 10 months.
So we would have been out of debt in 21 months, in this strategy as well
But we would have paid Rs.62,800 as interest
Roughly we would have paid Rs 6500 more than the debt avalanche strategy.
But this helps us to pay off our debt psychologically faster.
Some like the logical approach and some like the psychological approach.
There is nothing wrong with either of the approach.
Paying off debt is our goal.
Of these two approaches, we have to choose the one that works out well for us.
And one more thing,
if your friend or your relative is asking for money as loan,
what would you say?
If you are in a situation like that, you should ask yourself just one question.
Do I need this relation or not?
If you think that you need this relation, give the money that you can give it for free, not as a loan.
If you think otherwise, give the loan.
Because like the saying in our annachi shop, Debt breaks relations.
There is no doubt there.
We will soon meet again in the next video. Thank You.