Welcome back! Last week, we discussed the Rule of 72 and how your money grows at different interest rates. If you missed it, you can scroll down in the Features section and see the previous issue.
Now that we know how interest rates can work for you, let’s talk about how they can work against you and, unfortunately, I have to bring up that four-letter word… DEBT!
Understanding the Two Types of Debt
There are two types of debt: installment, or fixed, and revolving.
Fixed debt is usually an installment loan, such as a car or home loan. Most fixed-rate loans have a set interest rate, but some installment loans can have a variable rate. You may have seen a lot of ARM’s (adjustable-rate mortgages) before the mortgage crisis of 2008.
Most fixed-rate loans have a set number of months before the loan is paid off, and you know exactly how much is applied to interest and principal each month based on the amortization schedule.
If you have a 60-month car loan at 8.5%, in 5 years you will own the car with no further payments.
How Fixed Loans Slowly Pay Themselves Off
In the beginning, most of your payment is applied toward interest, and then a small portion to the principal, which is the amount you borrowed or the remaining loan balance.
As you make payments, more of your payments start being applied to the principal, and you eventually reach a point where 50% is applied to interest and 50% is applied to the principal.
After that, the amount applied to principal becomes greater than the amount applied to interest, and the loan is eventually paid off because more of the payment is eating away at the principal balance.
Why Revolving Debt Is a Different Beast
Now, revolving debt is a whole different beast.
Revolving debt includes credit cards, lines of credit, or store accounts. Lately, I have been seeing these a lot with mechanics and truck drivers financing tools and large toolboxes.
Revolving debt can last forever for a variety of reasons. One of the biggest reasons is the high interest rate.
If you have a new card with an 18% interest rate and charge $3,000 and only pay the minimum payment, it will cost you $2,002 in interest and take at least 10 years to pay it off.
The Dangerous Truth About Minimum Payments
The second reason revolving debt can last so long is because of the minimum payment requirements.
The minimum payment is usually 3.5% of the balance or $20. So pause here and think about this…
If your minimum payment is 3.5% of the balance, and the balance is going down, what happens to the minimum payment? It goes down as well.
So if you are paying less in minimum payments over time, the revolving debt can last forever.
The third reason is that most people pay a day before the due date, on the due date, or after the due date. If the payment is posted late, late fees can eat up the amount that would have been applied to the balance or even cause the balance to increase.
(The fourth reason was a two-cycle payment system. A two-cycle payment system, or double-cycle billing, was a credit card interest calculation method that based finance charges on the average daily balance of both the current and previous billing cycles. This practice was federally banned in the United States and eliminated in the Credit Card Act of 2009.)
Fixed Debt vs. Revolving Debt: A Shocking Difference
Now that we have explained all of that, let’s look at the huge difference between a fixed and revolving loan.
We are going to use a balance of $20,000 and the same interest rate of 8.5%.
Fixed Loan Example
Car loan for $20,000 at 8.5% for 5 years:
- Monthly payment: $410.33
- Total paid: $24,619.80
Revolving Debt Example
Tools financed for $20,000 at 8.5% on a credit card:
- Initial minimum payment: $143.67
- Total paid: $180,265.97
- Payoff date: May of 2126, exactly 100 years from now
Why Understanding Debt Changes Your Future
So how do you tackle debt and eliminate it so you can save more for your future goals and dreams?
I am glad you asked.
Come back next week for Issue #4, and we will explain the best ways and methods to eliminate debt.
I recently sat down and created a debt elimination plan for a client that will save her over $48,000 in interest and shave 17 years off her debt freedom date so she can retire with dignity and no debt.
I can’t wait to show you what we did and how we will accomplish her goal.
Market Insights
- Stocks rose last week as peace talks picked up while investors cheered better-than-expected economic news and Q1 corporate results.
- The S&P 500 rose 2.33%, the Nasdaq rose 4.51%, and the DJIA rose 0.22%.
- Last week was the sixth straight week of gains, and the S&P and Nasdaq hit all-time highs.
- Q1 corporate earnings reports were better than expected, and the April jobs growth report helped fuel the market.
- New home sales data released two weeks ago showed sales for both February and March exceeded expectations.
Thought for the Week
“The fool doth think he is wise, but the wise man knows himself to be a fool.”
— William Shakespeare
About Frederick Hogsett, Jr.
Frederick Hogsett, Jr. is a licensed financial coach with almost 30 years of experience helping individuals, families, small businesses, and nonprofit organizations.
He recently opened an office in Savannah, Georgia, and can be reached at (803) 463-2773 or by website at www.livemore.net/fhogsettjrclient.
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