What one can do when loan EMI is very high? High loan (EMI) always hangs like a heavy sword on the borrowers neck.
The swing of the sword is locked by ones income from job. The larger is the loan (EMI) heavier will be its impact.
But till the sword is not swinging there is no problem.
Income from job works as a lock for the swinging sword.
But how reliable is this lock?
When one is paying high EMI’s, being dependent on the income alone is not advisable.
When loan EMI is very high, one must take steps to reduce the EMI.
Target is to reduce the weight of the sword and make it ineffective.
Sword made of heavy steel will sever hard. But a sword made of paper is harmless.
Even when loan EMI is very high, it can be gradually brought down by making regular prepayments.
Prepayments can reduce the EMI.
One can also prepare a shield to prevent self from the impact of swinging sword.
The shield is emergency fund.
The bigger is the emergency fund, thicker will be the shield. Thicker shields (large emergency fund) will provide longer protection.
In this article we will talk about loan prepayments to reduce EMI, and emergency fund creation.
The first question that a borrower will face is, which is more important, prepayment or emergency fund creation?
To understand this, lets take the analogy of the swinging sword again. Emergency fund (shield) will provide immediate protection.
In case of loss of job (income), emergency fund can provide immediate relief.
It can buy time to recover from the loss.
Prepayments focused on EMI reduction is like scrapping pieces of metal from the heavy sword (large EMI).
The process is slow and it will take time to see a noticeable change.
But the advantage of prepayment is that, the effect is permanent.
It reduces the weight of sword (debt level) once and for all.
Over a period of time, regular prepayments brings down the EMI level substantially.
I personally prefer creation of 3 months of emergency fund before making prepayments to reduce EMI.
Once a sufficient emergency fund is created, the process of making regular prepayments can start.
In this article we will see how to manage the swinging sword:
- Build a shield : Emergency Fund &
- Reduce weight : Make Prepayments to reduce EMI.
#1) Build Emergency Fund
Before one starts to build an emergency fund its important to budget all expense first.
Once all expense are budgeted, each line item must be categorized between unavoidable & avoidable expenses.
Unavoidable expense are those expense which will continue to build even during hard times (like job loss).
Avoidable expenses are those expenses which can be curtailed or stopped during hard times.
All those expenses which has been tagged as “unavoidable” are the ones that need emergency funding during hard times.
I have personally categorised all of my expenses like this. It gives me lot of clarity about my spending habits.
Moreover, it also keeps me grounded as I always know which expenses are avoidable and which are unavoidable.
Needless to say that, in order to create a sufficiently big emergency fund it is essential to ‘save more money’.
Here again, budgeting of all expense will clearly identify how much money can be spared for ‘savings’.
Suppose, sum total of all emergency expense is $1,000.
As our rule of thumb, one must develop 3 month worth of emergency fund ($1,000 x 3 = $3,000).
But it is not easy to accumulate $3,000 in one go. It will take time for funds to grow to $3,000 levels.
If one is able to save $300 per month, building $3,000 will take 10 months time.
Saving money is a skill that must be learned over a period of time.
Majority people are not naturally good in saving money.
But following few basic rules will help developing the savings instincts.
Follow these simple steps and you will see surprising improvement in your saving habits:
#1 Step : Create an expense budget
#2 Step : Identify high expense line items.
#3 Step : Try reducing high expense line items by 0.5%. Do not make huge reductions initially.
#4 Step : For other smaller expenses, try available economical alternatives. Like taking a motor bike to work instead of car, changing your internet plan etc.
#5 Step : Do not avoid budgeting for miscellaneous expenses. Keep funds allotted for activities like entertainment, dining out etc.
No matter how hard you try, these expenses will anyway happen. So better is to prepare a realistic budget.
After following these five steps, people will start generating sufficient savings.
These savings in turn will be useful in building emergency fund initially, and later on to make prepayment.
#2) Make prepayments to reduce EMI
Once you have build 3 month worth of emergency fund, it is time to start making prepayments.
Every prepayment made will scrap-off a tiny weight of the sword (reduce EMI).
But please note that, the weight reduction will happen only in micro-grams.
Hence effect of initial prepayments will not be very visible.
But do not be discouraged. Give yourself a target and keep making regular prepayments.
I will advice you to keep a track of your prepayments and EMI lowering in an excel sheet.
Take a printout of it and stick it on your wall. Keep looking at it every day.
It will encourage you and your family to make bigger prepayments.
Because, the bigger will the prepayment amount, leaner will become your EMI.
Effect of slow & continuous erosion of metal (prepayments) will be clearly visible over long term.
If one has chance to take bigger chunks (large prepayment) its effect will be instantly visible.
Advice: When you are budgeting your expenses in step 1 above, make sure to allot a specific value for prepayment.