Compound Interest Works Against You

Practical Advice for People with Debt:

Over and over you will hear people tell you what to do about your debt. They will tell you to pay it off. Others will tell you to wait it out and just pay the bill on time. Each side has reasons to convince you and the reasons make sense as well. All of this internal personal finance bickering can easily leave you feeling helpless. What does this mean though, really? Does it mean simply that you can stop worrying about your debt? Hardly. Next month, sure as the sunrise, your credit card or student loan bill will come and they’ll be in the same situation that they are in right now.

Debt Repayment: A Real Tempest in a Teapot

As I’ve already explained, some people will say to pay it off, others will say wait. But, the beauty of personal finance is right in it’s name. It’s personal. But the best way to get to the correct decision for yourself is to understand how loans and debt and compound interest works. We don’t generally learn much (if anything) about this in school. Instead, we are left graduating high school, heading to college, and within just a few years, usually over-our-head in debt.

Are you Interested?

All debt comes with a price: interest. Even so-called no-interest or 0% financing comes with a price. When a debt is incurred, for the most part, there is some kind of interest rate attached to it. Interest rates are annual interest rates, for the most part. This means, that to find out what you will pay in interest for the year, it is generally as simple as multiplying your balance * the interest rate. This interest is the amount that you will owe. However, in a case where you pay signficant amounts of interest on your debt, the compound interest works against you.

Should You Pay Off Your Debt Early?

This is the question that most people come to when they think about debt repayment. However, the question is not should you pay it off early. Instead it is actually three questions:
1. How comfortable am I with my current cashflow?
2. How much money extra can I pay on this debt?
3. What is my expectation for near future cashflow and payments?

Once you can answer these three questions, you will be on your way to deciding if an additional payment on the principal of your debt makes sense for you.

If you feel that the current cashflow and your cashflow for the immediate future are solid, it might put some weight on the idea that you can afford the extra payment to principal on the debt. On the other hand, if a job situation is dicey, or if the car needs some repairs, you might want to just wait a while before you pull the trigger.

A Race Against Time

Understand that for most debt, the earlier you can reduce the principal, the better. For example, if you know you have 500 dollars extra to pay on the debt, you would want to put this money on the debt as soon as possible, say when the total outstanding was over 7000 dollars at 7% interest. If instead, you pay the bill monthly for about 120 dollars/month and at the end, when there are only 4 or so payments, you finish the debt with the 500, you will have wasted close to 300 dollars with of interest that you could have otherwise saved by just putting the principal payment down at the beginning.

Why You Should Be Interested

The amount of interest to be saved also depends largely on the amount to be applied. If the extra is only the amount of a single monthly payment, unless you can do this regularly going forward, it might not make sense to apply the money this way. The reason is that the principal that will be saved by a single additional monthly payment made 30 days early will do very little in terms of saving money in interest over the long run. It might in fact be better to bank the money in case of a financial emergency to ensure that you don’t get behind on payments. This would be much more costly in terms of your credit score and possible loan/credit card default rates.