Principle vs. Interest
Disclaimer: I am not in anyway legally qualified to give anyone financial advice!! DO NOT do something just because I said it sounded like a good idea. Open your mind to my thoughts, take it to a professional advisor or someone else you trust, and only then make your decisions.
I want to keep this post simple and to my two main points:
- There is "good debt" and "bad debt".
- The way you pay your debt makes a difference.
My reason you should keep reading:
Everyone, but especially young people, need to understand the components of debt, the real costs, and how to make choices that will set you up for financial security and keep you out of the debt trap.
First let me define a few terms. (Hopefully the graphic helps!)
Loan Balance—how much you owe on your loan
Payment—the set amount the bank tells you to pay every month; they calculate it with an equation that you don't need to worry about right now
Interest—the percentage of money the bank charges you to borrow their money; interest is calculated by dividing the interest rates by the number of payments per year and multiplying it by the loan balance ($10,000 x .10/12 = $83.33)
Principle—this is whatever is left of your payment after the bank takes the interest; this is the amount that actually gets paid toward your loan balance, which is why the loan balance after the payment is $9,951.18 ($10,000-48.82); the principle you're paying will be your best friend if you are paying off big debts (i.e. student loans)
Point #1: Good Debt and Bad Debt
(Remember this is just my opinion!)
Good debt is used to help people buy assets (remember, those things that are going to help you make more money). For example, I want to own rental houses, but I barely have enough cash for a small down payment much less a whole house. But the bank will do me a huge favor and lend me the money so I can get started. If I make good decisions, my investment will be profitable, I'll make money, the bank will make money (the interest I pay them), and we'll all go home happy and thankful! This type of debt encourages and makes a way for financial growth. This type of debt can empower you to reach your financial goals. It should still be treated with caution and used wisely.
Other examples of good debt: student loans, business loans
Bad debt is accumulated when people live above their means. I'm not pointing any fingers and I'm not saying that you should never use "bad debt". A common expense that often requires bad debt is a car. This type of bad debt is usually paid off fairly quickly and for a reasonable price; however, it is purely expense and it is not a way to build assets which is why after school I'll be looking for a very cheap (and hopefully not too ugly) car that I can afford to pay cash for. Credit card debt is a far worse type of bad debt, and far more dangerous. The high interest rates and high spending limits make them a battle ground for less conscious spenders. This type of debt consumes and imprisons. This type of debt is not something to take lightly.
Other examples: extravagant home loans, vacation loans, loans for big toys (boats, expensive cars)
Be very, very careful what kind of debt you let into your lives. And if it is necessary, take full responsibility for learning to pay it off. My next point contains a few things I've learned about that.
Point #2: The way you pay your debt makes a difference!
Every payment of your loan is not equal! Well, the impact of each payment is not equal...
You see, the interest charged each month is a percentage of the loan balance, so in the early months of your loan most of your payment will go to paying interest (refer back to the graphic above). That leaves a much smaller part of your payment that actually goes toward paying off some of your loan balance. Then the next month, your balance is still almost as high as the month before which means your interest will be also... It sounds like this never ending spiral of never ending payments... and sadly, sometimes it is...
But it doesn't' have to be this way.
Option #1: Larger down payment
This helps because it decreases the loan balance from the beginning. Smaller balance, less interest paid.
But what if you simply don't have any money right now?
Options #2: Multiple "tiny down payments" along the way (as often as possible!)
This is the most powerful concept that I've learned about paying off my debt.
Plain and simple, I owe my lenders interest every month (and I'm not upset about it, I'm really thankful I could get the loans so that I could get an education! I couldn't have done it without my lenders!). After I pay that, anything left from my payment goes toward my loan balance. So what if I added an additional $10, $50, $100 a month to my payment? An extra $10, $50, $100 a month would come off my balance!
This is where progress is made! Every dollar I pay above my monthly payment is directly subtracted from my loan balance! And the results are amazing! By doubling my student loan payments, I'll cut the time I spend paying them from 10 to 5 years! And I will save myself thousands in interest!
And really what's an extra $100 a month? A few less clothes? Less expensive dinners out? One less trip to Walmart? There are endless ways to live more frugally in order to pay off debt faster. This is great news, particularly if you have bad debt that eats away at your wealth instead of building it up.
To sum everything up, make sure the debt you're in is necessary and worth the costs. The best way to pay less interest is borrow less money. The second best way, is to make your payments as big as you can possibly afford!
I know this seems oversimplified. But it's really not when you really think about it. Life is choices not chances. The choice is yours.
Make choices now that will set you up for financial success later. Every other area of your life will thank you for it.
With you and for you,