Most Australians reach a point in their lives when they have to take out a loan. Whether it’s to finance a new home, purchase a car, or to take care of an emergency, many people find themselves handing over a sizeable chunk of their income for loan repayments.
Unfortunately as a nation we’re not strangers to taking on more and more debt. As this graph shows, Australians owe over twice what we make in our annual net income.
Debt puts all kinds of restrictions on your cash flow. What’s more, if you’re struggling to make repayments it creates stress that can lead to all kinds of health problems in the long term.
Luckily, there are things that you can do to shorten your repayment period. By making a few rational financial decisions, you can shave years off of your repayments .
Of course, this is easier said than done. Getting out of debt requires a long-term strategy that entails commitment and careful planning. You may not even be aware of all the options at your disposal, not to mention where to begin.
If you need some guidance, here are some of the best tips for getting out of debt as soon as possible:
1. Pay Every Fortnight
Most banks will have you agree to a standard contract that comes with monthly repayments. People generally don’t give this another thought, as it seems as standard as they come.
Except you don’t actually have to pay once a month. You see, the reason why banks don’t suggest any other frequency is that they can make more money on interest. The interest compounds daily, meaning that each time you make a payment to lower your outstanding balance, you also lower the daily compounding interest.
So, it doesn’t matter if you pay the same amount every month. If you split the payment into two and make the first payment earlier, you will end up paying less interest. But you can do better.
Let’s say you have a $450,000 home loan over 30 years at 4% interest. This means that the total payments will add up to $773, 413. This is $323,413 in interest over 30 years. By changing your repayment cycle to fortnightly rather than monthly, you’ll end up making the equivalent of 13 months of payments in a year while also cutting into the interest with the higher frequency.
The result? You’ll pay $272,668 in interest over those 30 years, saving $50,745. This simple change will also shorten your repayment period by four years to 26 years.
2. Recycle Your Debt
Debt recycling is one of the best strategies for getting out of debt as soon as possible. Not only does it let you pay off debt much earlier, but it may also help you build wealth along the way.
This method entails pulling equity from your home and using it to invest in an income-generating asset. This way, you turn your non-deductible mortgage into tax-deductible debt. The focus shifts from the reason you took out a loan (to buy a home) to generating income (e.g. rent, dividends) to pay the loan back.
You can invest in another property, shares, or any asset that can generate income or capital gain or both. You use the income to make payments on your mortgage, which instantly saves you money on interest.
Then, as you lower your debt and build equity, you can increase your investment loan and use it for other income-generating assets. The balance of your mortgage keeps getting lower, and the size of your investment loan goes up, meaning you can deduct more from your taxes.
There are many ways of doing this, including:
- Recycling using a line of credit
- Recycling with interest-only loans
- Recycling with principal and interest loans
The ideal strategy depends on your financial situation and goals. The most important thing to remember here is that you need to be able to meet your monthly repayments for the investment loan. To do this, you need to start saving and learn how to manage your cash flow properly.
The potential income of your investment is not likely to meet the monthly loan payment. You may have to depend more on the capital gain.
Debt recycling can be quite complex, which is why people usually turn to professional help. You’ll need the right structure and your investments have to pan out, so you can never take this strategy lightly.
3. Use the Snowball Method
This is more of a behavioural change than a repayment strategy. It’s best for those who can’t get their finances in order and can’t stick to a rigorous repayment plan. Watch the video to see how this method works compared to the Avalanche Method we discuss next.
In a nutshell, this strategy involves organising the sources of your debt from the lowest to the highest and repaying them one by one. Don’t take the interest rate into account, but rather just order them according to the outstanding balance.
For the smallest debt, try to save up and pay it off as soon as possible. As for all others, make the minimum repayments and work your way to the top.
This is great for building confidence in your ability to manage your finances. It can motivate you to save as much as possible and get rid of one debt after another.
4. Use the Avalanche Method
One of the first rules of repaying your debts as soon as you can is to tackle the highest interest rate loans first. This is what the avalanche method is all about. With this method, you order your debt from the highest interest rate to the lowest.
Make the minimum repayment for all loans except for the first one on the list (highest interest rate). For this one you should make the repayments as big as possible to wipe out a good portion of that high interest.
The biggest downside of this method is that it requires discipline. While the snowball method focuses on short-term gratification and confidence building, this one can be quite discouraging in the beginning, especially if your biggest debts also carry the highest interest rates. It’s necessary to keep pushing through for the strategy to work.
5. Consolidate Your Debt
Debt consolidation can simplify your finances and help you get out of debt early. Instead of making multiple payments, you only have to make one monthly payment. As long as you manage to find a good deal at a much lower interest rate than your old debts, this can free up your cash flow and make debt repayment much more convenient.
Debt consolidation is most commonly associated with consolidating credit card debts, which have high interest rates but it can also work if you have a car loan or any other kind of personal loan. By transferring the balance of the higher interest loans into just one lower interest loan you can then simply start making repayments on the new loan, and save money on interest in the process.
For this strategy to be successful, you need to focus on finding low interest rate loans. At the same time, you need to keep your repayments around the original total.
6. Renegotiate Your Mortgage
Not everyone knows this, but your mortgage isn’t ironclad. You can renegotiate a better deal that will lower the total accumulated interest and make the repayment period shorter.
The first thing that you can do is to call your bank and mention that you’re thinking about going with a different lender. Hopefully they’ll want to keep your business and tweak the deal to make it easier for you to repay your mortgage.
It all boils down to asking for a lower interest rate. This can allow you to save quite a bit of money over the life of the mortgage. If needed, you may be able to structure lower monthly repayments so that you can focus on higher interest rate loans.
Of course, not all banks will be willing to negotiate. You may have to look for another lender or hire a good mortgage broker.
7. Overpay Each Month or Fortnight
Everyone has a few expenses that they can eliminate. It doesn’t have to be anything drastic, as even the smallest amounts of money saved can have a butterfly effect on your debts.
Take some time to track all your expenses. See if there’s anything that you can live without over the next few months or years.
After that, put the money aside and increase the payment on your debts whenever you can. If you concentrate on your highest interest rate loans, even $50 extra a month can make a lot of difference in the long run.
Free Yourself of Debt as Soon as Possible
People generally have two main goals when it comes to reducing debts: freeing up their cash flow for everyday expenses or getting out of debts early. You usually have to choose one or the other. To get out of debt early, you have to make higher regular payments, which might affect your cash flow. Conversely, making lower payments to free up your cash will extend the life of a loan.
Of course, getting rid of debt early is better for the long term. A simple way to do that is to refrain from spending money on unnecessary things and use it to pay off debt instead.
As you can see, there are little things you can do right now that will make a lot of difference in the long run. Think about cutting your expenses and making fortnightly repayments to start reducing debt right away.
As for the more complex strategies, it’s best to consult your tax or financial advisor before you commit. Negative features might lurk in an outwardly good deal. The moral here is that you need to choose the repayment structure carefully.
To determine the right strategy for your situation, take this quiz to see if a free chat with a financial planner can help you achieve your financial goals.