Wednesday, September 20, 2006

About Loans and the Effects of Interest

This post describes the Rapid Payoff feature of the Debt Manager, with more of an emphasis on the dollars and cents than the application itself.

Disclaimer

First off, I’m an engineer, not an accountant, banker, etc. I took a bunch of money-related courses in college, but I should not at all be considered more than slightly proficient in the area. Since you stumbled upon this on the internet, you should take it as such: information given by a complete stranger who probably doesn’t know as much about the topic as he thinks.

If the information that my application produces turns out to be wholly inaccurate and you do something really dumb as a result, let me know so that I can fix the application, not your mistake. To put it another way, I am not responsible for whatever you do with this. Seek professional advice when needed.

What’s the big deal?

The idea is to eliminate debt. The fastest way to do this is to pay a lot towards debt., thus minimizing the money wasted on interest. Let me reiterate that point: every penny you pay to the interest of a loan is completely wasted. I think people tend to understate the effects of interest so here’s a nifty chart I just whipped up:

Normal Loan Payoff


This shows the amount of money paid for a $150,000 mortgage at 6%, broken down into principal (blue) and interest (red). Remember, principal payments actually reduce the amount you owe, while interest payments do nothing for you. It isn’t until 18.5 years into the loan that you actually pay more to principal than interest.

If this loan runs its course, you will have paid $173,757.28 to interest--more than you paid for the house!

Now suppose you have an extra $500 each month that you can apply to this loan. The extra dough can come from trimmed expenses, money that was being used to pay for something else that’s recently been paid off, etc. Here’s what the things look like side-by-side:

Loans Compared


That’s a little crazy so let me explain. The three hollow lines that go only to month 150 or so are the accelerated amounts. This means that if you pay your normal payment each month, plus tack on an extra $500 to the principal, you will own your house in 13 years instead of 30.

With this method, you will pay an extra $78,000 extra over those 13 years (13*12*500), but will save $108,000 when compared to the 30 year payoff schedule.

Can’t afford $500? An extra $250 each month will cut the life of the loan to under 18 years and save you a cool $80,000. A mere $100 extra each month will shave more than six years off the loan and save you $45,000.

(note: those graphics were created pretty easily with Office 2007. Spiffy huh?)

Where am I supposed to get extra money?

Lots of places. You can sell stuff you don’t need anymore, switch to a cheaper car, move into a cheaper house, don’t eat out as much, etc. There’s even a way without doing any of that: stop financing new stuff. That is, when your car is paid off, you will suddenly have an extra chunk of change. Instead of buying a new car, keep the one that’s paid off and use what you were using on the car to pay off something else.

This method is known as snowballing because the more things you pay off, the more you will be applying to your remaining debts, while not actually increasing the total amount you spend on debt.

Will this actually work?

Yes, with one seriously huge condition: you must follow the schedule. If you do not apply the extra money, it won’t work. This program takes discipline, no doubt.

My hope is that by seeing the dramatic effects of Rapid Payoff in the Debt Manager, you may be encouraged. You can switch between traditional payoff and Rapid Payoff by toggling a checkbox.

As usual, posts related to the Debt Manager can be found in the Money category.