People ask me for
debt pay down strategies fairly regularly. The answer is always the same – it
depends. I’m not trying to avoid answering, but the answer does depend on
the balance, interest rates, payments, etc.
There’s another
concept that people don’t really think about, but it can make a difference in
how quickly you pay off debt and how much interest you pay over time -
Scheduled versus Simple.
Scheduled interest
is commonly found with mortgages and home equity loans (not lines of credit).
The principal balance is amortized (paid down) and interest is charged
according to a schedule over the life of the loan. Even if you make your
payment a day late, you still pay the scheduled amount of interest for that
given month.
Everyone knows
that if you pay extra principal on a loan, you save interest and shorten the
time to pay off that loan. But what people don’t know is when you
actually save the interest.
In a scheduled
interest loan, you save interest because you paid off the loan early. But the
interest you pay in any given month is still the same.
Take this example:
$35,000 loan
4% interest rate
10 year term
Based on those
terms, the normal payment would be $354.36 per month. And you would pay over
$7,500 in interest over those 10 years.
Instead, let’s
suppose you paid an extra $100 per month principal. You would pay off the loan
in 7 years, 9 months. And you would only pay just over $7,000 in interest, thus
saving over $500 in interest over the life of the loan.
But when do you
actually save that interest? You avoid the interest payments from 7 years and
10 months until the end of the 10 years - the gap in time on the lower right of
the chart.
Simple interest
loans are usually credit cards, auto loans, and student loan and interest is
calculated differently. Instead of a regular amount any given month, the
interest is based on the number of days since your last payment and the balance
of the loan.
The US Department
of Education shows how interest is calculated on a student loan:
A way to pay less
interest is to pay more often. If you get paid weekly, bi-weekly (every other
week), or semi-monthly (twice per month), consider making a payment each time
you get paid. So if you get paid twice per month, pay ½ of the regular payment
each paycheck.
In the formula
above, the “number of days since last payment” would drop from 30 to 15, and
over the 10 years, you would save a little in interest.
Let's compare the results using the same terms from the previous example:
Making regular monthly payments would result
in just over $7,500 in interest.
Making ½ payments
every 15 days would result in $7,487 in interest.
It’s not a lot in savings,
but you do save some.
Simple interest
loans such as credit cards, auto loans, and student loans typically don’t have
pre-payment penalties so if you get a bonus at work, or earn some extra money,
you can make an extra payment. And you would benefit from saving interest now
instead of at the end of the loan in a scheduled interest loan.
BEWARE though if
you make late payments. Even paying 1 day late adds interest - paying in 31
days instead of 30, for example. Every time you pay late, more of your payment
goes to interest than principal, so if you’re expecting to pay off a loan in 10
years, it might not be paid off in 10 years! And you really will have debt a
lot longer than you expect.
On a somewhat
related note, one of the challenges people have when trying to save or improve
finances is maintaining the discipline to keep their “eyes on the prize” when
it means denying oneself. With my younger son going off to college in the fall,
my wife and I tightened our belts and committed to paying off some debt and
building more savings.
We don’t want him
to end up with a ton of student debt, nor do we want that.
In the few months
we’ve been at this, we’ve made some progress. We’re paying down debt and have
more in savings.
AND IT’S KILLING
ME!!!!
I like my iced tea
from Dunks. I like going out to eat occasionally. And we still do, just not as
often. Denying myself little things like these make it tough to stay disciplined!
So, my advice to
you is this – while you are saving, paying debt or whatever you’re doing to
improve your finances, take a little bit of money to reward yourself. You’ll
stick with the program a lot longer if you can enjoy the journey along the way.
If you continually deny yourself, you won’t stick with the plan.
Yes, I’m sticking
with our plan, but it can be pretty hard driving past Dunks and not turn in!
What do you think
of these topics? Please comment below.
Also, please share
this blog with anyone you think may find the information useful!
