Managing Debt

There are generally two kinds of debt: good debt and bad debt.  Good debt can be interpreted as things like mortgages, student loans, or even car notes.  For many individuals, these are necessary evils that must be shouldered in order to reach higher goals in life.  Bad debt, on the other hand, generally centers around credit card debt.  A rough cutoff point between good debt and bad debt is 6%.  If you’re paying an annual rate of 6% or less on the debt, that’s pretty “good.”  Anything significantly over 6%, and definitely anything in double digits, is pretty “bad.” Understanding how to manage or minimize debt throughout your life is critical to financial stability.

CalculatorUnderstanding Principal and Interest

Suppose you had a $1,000 balance on your credit card that charged a 25% annual interest rate.  Most credit card companies only require you to pay approximately 3% of the outstanding balance every month as your minimum payment.  So, on a balance of $1,000, that’s only $30 per month.  How long do you think it will take you to pay down this entire debt, if you only made the minimum payment every month?

Well, I’m sure many of you can eyeball that to cover $1,000 at $30/month would take you about 33 months, if there were no interest charges.  But the credit card company has to make something, so how long do you think it will take?  35 months?  40 months? 

Try over 57 months. 

And that’s making some favorable assumptions that probably aren’t true (so, in reality, it will probably take a few months longer to pay this down, but we’ll pretend we’re in a fantasy world where the credit card people are your friends and stick with the 57 months) .

In other words, you’re going to spend the first 33 months paying off the actual amount you borrowed to buy whatever it is that you bought and the next 24 months simply paying all of the interest you owe to the credit card company for letting you borrow that money.  All in all, you’ll end up paying at least a total of $1,725: spending almost three years to pay back the $1,000 you borrowed and the next two years to pay $725 in interest!

What’s the way out of this mess?  Clearly, you’ve got to make more than the minimum payment each month.  But why is that so effective?  Well, every month you make a payment, part of that payment goes towards the principal of your balance (the amount you borrowed), and the rest goes towards the interest you owe to the credit card company for that period.  In our example above, if you only made the minimum payment, here’s how it would break down:

Interest: $21 (this goes directly into the pockets of the credit card company and does not reduce your outstanding balance at all)
Principal: $9 (this is what reduces your balance…from $1,000 all the way down to $991)
Total: $30

Now, what if you simply sent in an extra $10 this month, making a payment of $40 instead of $30?  The beauty of that extra $10 is that it goes entirely towards reducing your principal.  The entire payment now breaks down like this:

Interest: $21
Principal: $19
Total: $40

The extra $10 you put towards your credit card bill more than doubled the amount of principal you paid down!  What if you sent this extra $10 every month?  How long would it now take you to pay off your entire balance?

Only about 37 months.

That’s 20 months less than if you only made the minimum payment every month.  The magic here is that you’re avoiding having to pay the 25% interest rate on those principal reductions by making those extra payments to reduce the principal more quickly.  Think of it this way: you’re basically earning a 25% rate on the money you’re using to pay down your credit card debt.  You’d have to search high and low to find an investment that would pay you a guaranteed 25%…at least legally.