Do you pay more than the minimum payment on your loans?
If not, you should start. By paying only the minimum, you are missing out on thousands of dollars.
Do you know how interest works?
If you have debt, you have interest. But I am sure you know this already, so this is just a review (hopefully).
The expectation is that when you borrow money, you will return the money back to the lender at some point.
The expectation varies depending on the loan. For credit card companies, they expect their money as soon as possible. In other situations, like mortgages, the payback period is set (usually 15 years or 30 years).
Let’s remember the difference between borrow and take. The essence of the word borrow is used with the intention of returning. Take means to gain something and keep it. When we borrow money, we are supposed to give it back to its owner. It is a simple concept. When we take out a loan, we are operating with other people’s money (OPM).
Interest is the Problem
When it comes to borrowing money there is a fee applied for doing so. The fee is called interest. The bank/credit card company could do anything they want with that money, but instead, it lent it to you, the borrower. Now their money is tied up. So they charge a fee for tying their money up.
Interest is what makes debt so deadly. Depending on how the loan is structured. It can go sky high. It is almost always a percentage of the total loan.
“With so much credit available, there are bound to be casualties. ” Vern Countryman, Professor at Harvard University.
It’s All about the Rates
Interest is a moving target. It has the potential to grow depending on how long you take to pay off your loan.
Credit Cards are like student loans on steroids. This is for two reasons:
1. the interest rate is high
2. People continue to use the card and add to the outstanding balance
Interest rates on credit cards hover around 15 – 20%. Almost triple a student loan! Why is it so high? It is because card companies take on more risks. This is called an unsecured loan. Credit cards are unsecured, meaning they are not directly connected to property that a lender can seize of the cardholder fails to pay. For example, a car loan is secure. If you don’t pay your car payment, they will seize your car.
Tons of Americans don’t pay off their loans. If you don’t pay, it is called default. But the purposes of this post let’s assume you pay at least the minimum.
So what is a minimum payment?
Investopedia defines the minimum payment as “the smallest amount of a credit card bill that a consumer can pay, to remain in good standing with the credit card company”. In other words, the credit card company assigns a minimum payment amount for you, the consumer, to stick to. If you fall below that, there will be some problems.
How do they calculate it?
Usually, the minimum payment equals from 1% to 3% of the outstanding balance.
Here is the tricky thing
What’s tricky here is that while your credit card has a credit limit, your balance can go way beyond that limit when you include interest.
But it gets worse. There is another financial term you should know. It’s called compound interest. Compound interest is the concept of getting interest on top of interest. The amount “compounds” or grows exponentially.
Let’s say you $1000 on a credit card.
Here are the terms: 10% interest rate, with $20 minimum payment
Pay only the Minimum
If you decide to pay only the minimum, it will take you 90 months to pay your card off.
That’s 7.5 Years!
Pay more than the Minimum
If you decide to pay $25 instead of $20, it will take you 49 months to pay your card off.
A difference of $5 reduced the payback period to by almost half! And you save $200 in interest!
Imagine if you added multiple “0” to these numbers. Over time compound interest can have a major effect. Compounding can work for you, as in investments, or against you, as in debt.
Einstein, according to some, said this about compounding: “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.”
As the total increases, the interest increases even more. If not stopped, it will keep growing and growing. There is no limit.
The same holds true for student loans. Instead of minimum payments, you pay a fixed amount.
The point here is this: loan interest is like financial quicksand, it will keep dragging you down and down until it swallows you.
Have you ever felt it is taking forever to pay off your loan? Paying the minimum will guarantee that it will take forever. There are 2 factors at play here.
It takes longer because paying at the minimum causes the loan period to extend unnecessarily. The bank wants you to take your sweet time in paying the loan. The more time you take, the more money they make.
As you can see in the illustration, the compounding interest is working against you. When you pay off each monthly payment, you assume that your balance will get smaller, proportionately. Unfortunately, that is not true when interest is involved. Because of interest, your loan will grow on its own. A minimum payment will not put much of a dent in it.
For student loan payments, your payment goes towards interest, then to your principal balance (the principal amount refers to the original amount you borrowed). In reality, your monthly loan payment may not go directly to your principal. For example, if you pay $100 towards your loan, only $60 actually go towards paying down the loan. The remaining $40 will go towards paying interest.
So what can we do?
The first thing you should do is to set up an automatic withdrawal. In your budget (assuming you have one), make this a non-negotiable. I trick I used on myself is add the loan amount to your rent. Doing this will force you to adjust your lifestyle to free up cash for the loan payments. Again, you have to pay and I suggest you pay more than the minimum. Any amount will do. Every little bit counts.